Mel & Bud, Inc., is a printing company specializing in the production of coffee bags and frozen food bags. The company’s board has asked you to complete an analysis for their intended expansion into a new production space; a large mill building in close proximity to the current location will be refurbished to accomplish this task. The executive team has provided some information regarding the project, which follows.
About the Machine
The following are base assumptions regarding the equipment. Note that the cost of the building lease is included in the Cost of Goods Sold as indicated. Initial investment outlay is $70 million, with $50 million for machinery and $20 for net working capital (inventory). Life of the equipment is 5 years; the increase in annual revenues is $60 million annually. The company’s gross margin is 60% (excluding depreciation). Use straight line depreciation to calculate the cash flows. Selling, general, and administrative expenses are 3% of sales. The company’s tax rate was negotiated at 30% for the new operations.
Weighted Average Cost of Capital
Weighted average cost of capital is based on the following fact pattern. Capital structure of 40% debt and 60% common equity, there is a 30% tax rate. The cost of debt is 8%, while the company beta is 1.1. In addition, the risk free rate is 1%, and the market return is 11%.
1. Using Excel, create a spreadsheet that calculates all relevant cash flows (i.e., initial investment, periodic cash flows, and terminal value).
2. Compute the weighted-average cost of capital (WACC) for the chosen firm on your spreadsheet. Take this number out to the nearest hundredth of a percent (e.g., 33.33%). There is no preferred stock in the company. Determine the weight of debt and common equity by the current market value.
3. Using Excel equations, compute the NPV and IRR.
4. There is a possibility that the cash flows from revenues will decrease by 50% if the demand for coffee bags decreases in favor of single serve coffee cups. Likewise, the net working capital will be cut by 50%. Given this assumption, recalculate the NPV and IRR for this scenario. Would you advise Mel & Bud to engage in this project if this was the reality of the marketplace competitive environment? Your answer should address the change in NPV and IRR versus the original scenario.