Automated Tellers Inc, a major manufacturer of ATM machines reported the following information about its financial structure:
Debt: 6,000 bonds outstanding, 8% coupon rate paid annually, 10 years left to maturity, $1,000 par value, 6% yield-to-maturity.
Equity: 200,000 shares outstanding trading for $60 per share; book value per share $27; beta is 0.75. Also, the expected market return is 10%, and the risk-free rate is 5%. The company faces a 35% tax rate.
The company is considering investing in a new lucrative business manufacturing electronic voting machines in time for the 2012 presidential elections. The company feels that this project is similar in risk to its existing business.
The company estimates sales for the product of $600,000 in each of years 1 and 2, $2,300,000 in each of years 3,4, and 5, and $2,100,000 in year 6. Cost of goods sold (not including depreciation) will be 50% of sales, and the selling and administrative expenses will be 10% of sales. The project will require an investment in fixed assets in year 0 of $3,000,000, which will be depreciated to 0 using the straight-line method over 6 years. The firm can build the manufacturing facility on a property that it already owns, or buy a similar property. The property can be sold for a market value of $500,000. The firm already spent $1,000,000 on research and development expenditures related to the project.
a) What is the appropriate discount rate to use when evaluating the new project?
b) Should Automated Tellers undertake the new project?
c) The firm expects that if the project is continued after year 6, the operating cash flows will grow at a rate of 4% forever, but the project will require an additional investment of $4,000,000 made at the end of year 6.