Problem:
You've been hired fresh off your Augsburg MBA as a financial consultant to the Mayo Clinic (MC), a new, for-profit, publicly traded firm that is the market leader in kidney dialysis systems (KDSs). The company is looking at setting up a manufacturing plant overseas to produce a new line of KDSs. This will be a five year project.
The company bought some land three years ago for $6 million in anticipation of using it as a toxic dump site for waste chemicals, but it built a piping system to safely discard the chemicals instead. If the land were sold today, the net proceeds would be $6.4 million after taxes. The company wants to build its new manufacturing plant on this land; the plant will cost $9.8 million to build. The following market data on Mayo's securities are current:
Debt: 25,000 6.5 percent coupon bonds outstanding, 20 years to maturity, selling for 96 percent of par: the bonds have a $1,000 par value each and make semiannual payments
Common Stock: 400,000 share outstanding, selling for $89 per share; the beta is 1.20
Preferred Stock: 35,000 shares of 6.5 percent preferred stock outstanding, selling for $99 per share
Market: 8 percent market risk premium; 5.20 percent risk-free rate
Mayo's tax rate is 34 percent. The project requires $825,000 in initial net working capital investment to get operationa1.
The manufacturing plant has an eight-year life, and Mayo uses straight-line depreciation. At the end of the project (i.e., the end of year 5), the plant can be scrapped for $1.25 million.
The company will incur $2,100,000 in annual fixed costs. The plan is to manufacture 11,000 KDSs per year and sell them at $10,000 per machine, the variable production costs are $9,300 per KDS.
Mayo's president wants you to throw all your calculations, all your assumptions, and everything else into a report for the chief financial officer: all she wants to know is what the KDS project's NPV is.