Question

You are the Chief Financial Officer and lead Project Development President for a snack. You are presented with a few options about what to do next for value-creation from your teams. However, you must evaluate each project and then make the ultimate choice on the project acceptance.

The firm you work for is a large publicly traded company. It currently has 10,000,000 shares outstanding and 200,000 bonds outstanding. The company's most recently paid dividend was $3 per share, this dividend grows at 3% per year indefinitely. You also know that the company's current share price is $45. You also know that the beta of the firm is 1.2 and the expected return on the market is 9%. The most current rate offered on a T-bill was 1.9%. The bonds for the firm were all issued on the same day in the past, November 2010, and have a maturity date of November 2040. They pay 8% coupons, are paid semiannually, and were originally sold at full par value. These bonds possess an attractive yield and are currently priced at a premium, $1,200. The company tax rate is 21%.

Project 1: This new project will build avocado chips. It will cost $25,000,000 today for a new building and machines. We would invest in NWC equivalent of 10% of capital expenditure cost today. We know that this project will bring in sales of $14,000,000 in the first year, growing at a rate of 25% for the first 2 years and growing at a rate of 12% for the next 4 years. We employ a MACRS 7-year depreciation scale for all CAPEX. In year-end 3, we will have to purchase $9,000,000 in new machines. Net working capital account will be 25% of sales for each year. Costs of goods sold will be 50% of sales until we get the new machines at which they will drop to 38% of sales. After year 6, we are quitting the entire project and liquidating all, we can sell the original machines for $4million and the new machines for $4million. This project is in line with a new product division that has similar risk levels to existing operations.

1 2 3 4 5 6 7 8

MACRS 7-year 0.1429 0.2449 0.1749 0.1249 0.0893 0.0892 0.0893 0.0446

MACRS 20-year 0.0375 0.07219 0.06677 0.06177 0.05713 0.05285 0.0488 0.04522

1) Which Project would you choose and why?

Answer 1

To choose a project, calculate its NPV by determining the WACC, forecasting cash flows, and considering growth rates, depreciation, and salvage values.

Step-by-step explanation:

To evaluate Project 1 for the development of avocado chips, we must assess its net present value (NPV) using the company's weighted average cost of capital (WACC) as the discount rate. To determine WACC, we would compute the cost of equity using the Capital Asset Pricing Model (CAPM), which will incorporate the given beta of the firm, the expected market return, and the risk-free rate from T-bills. The cost of debt is the yield to maturity on the existing bonds, considering the current market price and the fact that they pay semiannual coupons at a 8% rate.

After accounting for the tax shield on interest payments, we can proceed to calculate the WACC. The project's cash flows must then be forecasted, considering the growth rates in sales, changes in cost of goods sold, and the MACRS depreciation schedule for both initial and additional capital expenditures. Net working capital changes and the expected salvage values from the sale of machinery at the project's end should also be factored. With all these elements, we can compute the NPV of the project. If the NPV is positive, it indicates that the project is expected to create value for shareholders, making it a viable choice.