The ABC Co. is considering expanding its production capacity by 30%. The expansion will require $50 million initially. The net cash flow from this expansion is $4 million for the first year. The net cash flows are expected to grow at a rate of 5% each year for 4 years, but then slow to a 3% growth thereafter. The project has an infinite life. The ABC Co. estimates that the cost of capital (i.e., required return) for this expansion is 8%.
(1) should ABC Co. expand? Why? (2) If the market interest rate increases and thus the cost of capital for this expansion increases to 12%, would your recommendation change?
You would need to use the growing perpetuity equation for this assignment.