A company is looking at two different projects but can only afford one. The specifics of each project are described below. The project chosen will be financed by the same mix of debt and equity the company has now. While the cost of equity will not change from the financing, any new debt used will have a pre-tax cost of debt of 6.50%. As a result, the weighted average cost of capital, which will be used to calculate the projects' NPVs, will change. Your task is to analyze both projects under the guidelines described below and then decide which project should be undertaken.
Current Capital Structure:
Number of shares outstanding: 4,000,000
Current price per share: $70
Current cost of equity: 16.50%
Current market value of debt issue 1: $120 million
Current cost of debt (pre-tax) of debt issue 1: 8.40%
Current market value of debt issue 2: $100 million
Current cost of debt (pre-tax) of debt issue 2 : 9.00%
Current tax rate: 35%
Current WACC: This needs to be calculated
Project 1:
Cost: $250 million
Life: 10 years
Depreciation: Straight Line
Annual Revenues: $135 million
Variable Costs: 60% of revenues
Fixed Costs: $12 million
Addition to Net Working Capital: $8 million
Salvage Value: $0
Project 2:
Cost: $250 million
Life: 10 years
Depreciation: Straight Line
Annual Revenues: $130 million
Variable Costs: 55% of revenues
Fixed Costs: $16 million
Addition to Net Working Capital: $10 million
Salvage Value: $0
Analysis Guidelines:
1. Determine the amount of new equity and new debt needed to finance project 1 or 2 using the current proportions of debt and equity.
2. Determine the new WACC after financing, using 16.50% as the cost of equity and the new cost of total debt after adding debt costing (pre-tax) 6.50%.
3. Construct an income statement for projects 1 and 2.
4. Find per year Operating Cash Flow for both projects.
5. Find Cash Flow from Assets in each of the 10 year lives of projects 1 and 2 (remember to include the effect of additions to NWC).
6. Find the initial (base case) NPV for projects 1 and 2.
7. Find the NPV for projects 1 and 2 if annual revenues are +/- 10% from the base case.
8. Find the NPV for projects 1 and 2 if variable costs are:
a. 65% for project 1
b. 60% for project 2
c. 55% for project 1
d. 50% for project 2
Note: Use the base case assumptions when changing variable costs.
9. Find the NPV for projects 1 and 2 if fixed costs are +/- 10% from the base case.
10. Choose a project.