Question

Barfly Inc. manufactures and markets a line of non-alcoholic mixers sold to restaurants and bars. Barfly’s Creative Bartender has recently experimented with making alcoholic versions with the intention of bottling and marketing these directly to the public through appropriate retail outlets. Prior spending on R&D was $1.5 million and Barfly anticipates spending half of that again during the first year of the project to conclude R&D (for total R&D of $2.25 million). The cost of building the manufacturing line is estimated at $1,175,000.

Marketing projects revenues from the new product line will be 800,000 units in the first year, growth in years 2 and 3 at 15%, growth in year 4 at 10%, and 5% for year 5. While Barfly anticipates the product will have a longer life than 5 years, their initial projections are for a 5 year time horizon, fully depreciating the cost of plant and equipment over that time on a straight-line basis.

Revenue per unit is projected to be $2.50 in the first year, with prices rising by 3% per year thereafter. COGS are projected to be 68% of revenues, SG&A 7% of revenues, and the company’s marginal tax rate is 32%. Net working capital required for the project is expected to be 2% of revenues annually once the project is fully online in year 1.

Barfly’s balance sheet includes $3,000,000 in total capital, of which $980,000 is debt. The market yield to maturity on debt is 3.75%, the risk free rate on a 5-year Treasury is 3%, and the market risk premium is 6.5%. The company’s beta is 1.3 and the CFO uses the CAPM to estimate cost of equity.

1. What is the project’s NPV?
2. What is the project’s IRR?
3. Should the project be accepted?

Management has been studying the company’s capital structure and is considering using a small secondary offering of stock to pay down debt. The following data is used to determine the cost of debt under varying capital structures.

Debt ratio	Spread to Treasuries	Yield on Debt
0% - <10%	0.00%	3.000%
10% - < 20%	0.15%	3.150%
20% - < 30%	0.30%	3.300%
30% - < 40%	0.50%	3.500%
40% - < 50%	0.75%	3.750%
50% - < 60%	1.05%	4.050%
60% - < 70%	1.35%	4.350%
70% - < 80%	1.90%	4.900%
80% - < 90%	2.50%	5.500%
90% - < 100%	3.10%	6.100%
100% - < 110%	3.80%	6.800%
110% - < 120%	4.70%	7.700%
120% - < 130%	6.00%	9.000%
130% - < 140%	7.20%	10.200%
140% - < 150%	9.00%	12.000%
150% - < 160%	11.00%	14.000%

4. If Barfly issues $180,000 in new equity and uses the proceeds to repurchase (and defease*) existing debt, what would the resulting weighted average cost of capital be?
5. Should management move towards this capital structure? Why or why not?

Answer 1

		A	Total capital	$3,000,000
		B	TotalDebt	$980,000
		C=A-B	Total Equity	$2,020,000
		Wd=B/A	Weight of Debt	0.32666667
		We=C/A	Weight of Equity	0.67333333
		Yd	Market yield of Debt	3.75%
			Tax rate	0.32
		Cd=Yd*(1-0.32)	Cost of debt	2.55%
			COST OF EQUITY:
			R=Rf+Beta*Rp
			R=Required return =Cost of Equity
			Rf=Risk Free rate=3%
			Beta=1.3
			Rp=Risk Premium=6.5%
		Ce	Cost of Equity=3+1.3*6.5=	11.45%
		Wd*Cd+We*Ce	Weighted Average Cost of Capital(WACC)	8.54%
			Present Value (PV) of Cash Flow:
			(Cash Flow)/((1+i)^N)
			i=Discount Rate=WACC=8.54%=0.0854
			N=Year of Cash Flow
			$1.5 million already spent is sunk cost