Titan Inc. is considering introducing a new type of toy for cats. Titan expects the toys to become obsolete after five years when it will be discovered that toys only encourage cats to get anxious. However, the marketing group expects annual sales of $40 million for the first year, increasing by $10 million per year for the following four years. Manufacturing costs and operating expenses (excluding depreciation) are expected to be 40% of sales and $7 million, respectively, each year. The fixed assets necessary to produce the product will require an additional investment of $20 million at the end of the current year. The project will also require an immediate investment in net working capital (NWC) of $5 million. The equipment will be obsolete once production ceases and (for simplicity) the additional investment will be depreciated via the straight-line method over the five-year period. The corporate tax rate equals 35%. The risk free rate is 4%, the firm’s beta equals 1.2 and the market risk premium equals 5%. Were Titan to issue debt it would cost 8% in annual interest payments for five years, and the principal would be due in five years. The firm is currently all equity financed.
a. What are the expected future cash flow regarding the project?
b. Suppose that Titan finances the project entirely with equity. What is the NPV of the project?
c. Suppose that Titan finances 40% of the project’s initial investment with debt. What is the value of the project?
d. Suppose that the debt issue involves flotation costs of 1 percent of the amount raised. What is the value of the project? Assume that flotation costs are amortized over the lifetime of the project using the straight-line method
e. Suppose that the firm receives a loan guarantee from the Business Development Corporation (BDC) that reduces the interest rate on the loan from 8% to 3%. What is then the value of the project assuming that the firm must pay flotation costs (amortized over project lifetime) of 1% of the amount raised?