Part-A
Axolotl Corporation is a relatively small company in Eastern Washington that produces avionic parts and equipment for both the commercial airline industry and the military. The company recently won several contracts in 2012 for production starting in 2014. As a result, they need to expand their production and testing capabilities. As CPO of Aardvark, you are responsible for conducting the analysis of the capital project needed to allow the company to fulfill the contracts. Detailed discussions with the sales and marketing personnel indicate that sales in the first year would be $50 million and grow at 4% per year through the ten year life of the project. Accounting has indicated that the sales, general and administrative costs would be fixed at $4.5 million for the life of the project. Accounting also estimates working capital needs at 20% of revenue. Engineering and Manufacturing have indicated that the cost of goods will be 60% of sales.
The equipment is estimated to cost $52 million with an additional $40 million for installation. It has a ten year economic life and falls within the 7 year MACRS class for depreciation purposes. Engineering estimates that it can be sold for $3 million at the end of the project life. The new production facilities will also require a new building at a cost of $18 million. The building has a 39 year life and is required to use straight line depreciation. The market value of the building at the end of the project is estimated to be $12 million.
Aardvark's marginal tax rate is 35% and the project will initially use 15% as the cost of capital. Now that the contract is signed, determine whether this project will be profitable for the company. The board of directors requires all project analyses to include the net present value, internal rate of return, payback and profitability index. They also require an analysis of projects using +1-10% for revenue.
Since the information for a complete report is not presented here, your written report should include a discussion of the project as well as how the cash flows are determined and measures of project desirability are determined. Also, discuss the results of the sensitivity analysis and the implications of changes in revenue.
Part B
Since the analysis of the capital budgeting project indicates that the project should not be implemented, Aardvark has a problem. They have already signed the contract to produce the material. Management is now searching for ways to make the project viable and has settled on exploring the potential opportunities of a different financial structure. The board has asked you to evaluate the cost of equity and the weighted average cost of capital for three alternative ways to finance the project. First, finance at the existing debt to equity ratio and weighted average cost of capital. Second, finance the incremental investment with 50% debt and 50% equity and find the effect on the cost of capital. Third, finance the incremental investment with 100% equity. These two alternatives require a change in the cost of equity which results in a change in the weighted average cost of capital.
Use the following information in your calculation.
Market Risk Premium 0.07
T-Bill Rate 0.04
T-Bond Rate 0.065
Tax Rate 0.35
Beta 1.25
Long-Term Debt Yit;;ld 0.0675
Existing Discount Rate 0.15
Equity Shares Outstanding 31,470
Yield to Maturity at Issue Date 0.06
Par Value $1,000
Years to Maturity 18
Bond Pays Semiannually