Question

1. Doubleday Brewery is considering a new project. The company currently has a target debt–equity ratio of .45, but the industry target debt–equity ratio is .65. The industry average beta is 1.46. The market risk premium is 9.5 percent, and the (systematic) risk-free rate is 3.1 percent. Assume all companies in this industry can issue debt at the risk-free rate. The corporate tax rate is 27 percent. The project will be financed at Doubleday’s target debt–equity ratio. The project requires an initial outlay of $4,200,000 and is expected to result in a $405,000 cash inflow at the end of the first year. Annual cash flows from the project will grow at a constant rate of 3.5 percent until the end of the eighth year before leveling off at that same annual level (no longer growing) forever thereafter. Using the WACC methodology, value this project and tell whether it should be pursued.

Answer 1

We need to calculate the Net Present Value for this project which will tell us if this project should be pursued or not. The formula for the same is:

(Cash outlay) + CF1 / (1 + WACC) + CF2 / (1+WACC)^2 + CF3 / (1+WACC)^3 +.....+ CF8 / (1+WACC)^8 + PV of cash flows after the 8th year / (1+ WACC)^9

Now let's break down each of these terms:

Cash outlay = $4,200,000 (we'll take the negative of this figure as it's a cash outflow)

CF = Cash inflow for each respective year

In our case CF1 = $405,000

CF2 = $405,000(1.035) and so on till CF8

WACC = Weight of Debt*Cost of Debt*(1- Tax Rate) + weight of equity*Cost of equity

Let's calculate the weights of Debt and Equity first:

Debt / Equity =.45

Now, Debt + Equity should be 100% = 1

D + E = 1. Since, D = .45E

Then, .45E + E = 1

1.45E = 1, this means E = 1/1.45 = .689 or 69%

Now since, D = 1 - E, this means D = 1 - 0.69 = .31 or 31%

Now coming to the costs,

Since, the companies can issue debt at the risk free rate

Cost of debt = 3.1%

Cost of Equity formula = Risk Free Rate + Beta*Market Risk Premium

Hence, Cost of Equity = 3.1% + 1.46*9.5% = 16.97%

WACC = .31*.031*(1-.27) + .69*.1697 = 18.73%

Now, NPV = (4,200,000) + 405,000/(1+.1873) + 405,000(1.035)/(1+.1873)^2 + 405,000(1.035)^2/(1+.1873)^3 + 405,000(1.035)^3/(1+.1873)^4 + 405,000(1.035)^4/(1+.1873)^5 + 405,000(1.035)^5/(1+.1873)^6 + 405,000(1.035)^6/(1+.1873)^7 +405,000(1.035)^7/(1+.1873)^8 + PV of the remaining years / (1+.1873)^9

PV of remaining years = 405,000(1.035)^7/(WACC) = 405,000(1.035)^7/(.1873) =2,751,058

We are using the same level of CF as the 8th year because the question says that the cash flow will be the same thereafter. This will be the PV as on year 9. Hence, we will discount this value at the WACC for 9 years. Similar, to what we have done for the prevupre years.

Now solving the entire NPV equation, we get a total of (1,840,757). Since, this is a negative figure, it does not make sense to pursue this project as it will result in negstine shareholder value.

Hope this helps.

All the best!!