You were recently hired to evaluate the expansion of Tacky Toys Corp. Your boss thinks that to compete with your competitors (Cool Toys Corp. and Classy Toys Corp.) you must expand. She has asked you to advise her on the economic viability of several possible projects which involve buying a new machine, or several machines, to produce Tacky-Toys. Your boss wants you to look at 5 possible plans.
The machines will have an operational life of ten years after which time you will be able to sell them for a capital gain or loss. In all cases the machine’s purchase price and setup costs will be depreciated straight-line over 10 years. The marginal tax rate is 40% on any Operating Earnings Before Tax and on any capital gains or losses you receive at the end of the project’s life.
You have been instructed that funding for any of these plans must not alter your current capital structure. Currently, Tacky Toys has a capital structure of 60% equity, 30% debt, and 10% preferred stock. Tacky’s outstanding 20-year bonds sell for a price of $839.54. The bonds have a semiannual coupon payment of 9% and a par value of $1,000. Tacky’s marginal tax rate is 40%. To calculate the cost of equity capital you decide to use the constant growth dividend discount model. Tacky is currently growing at a constant rate of 6%. Tacky paid a dividend yesterday of 94 cents (D0=94 cents) and its stock currently trades for $10 per share. Preferred stock sells for $100 per share and has a dividend of $14.00. Some of the projects require working capital. There is no inflation; no floatation costs and all projects have the same risk, which is the same as the company’s overall risk. At the end of the project your company will fully recapture any working capital. The accounting residual value of all assets will be $0.
Plan C: Buy a super large machine for $2,000,000. This will require an additional $50,000 in working capital and $40,000 for setup. Revenues are expected to be $600,000 per year and operating expenses are $85,700 per year. In year 10 you will be able to sell the machine and everything else associated with the project for $250,000.
Plan D: Build a single extremely efficient machine. This will cost $250,000 and will require $75,000 for additional setup. This plan will require $7,500 in working capital. Revenues are expected to be $90,000 per year and operating costs are $15,000. Though the accounting value of the machine is 0, you believe you can sell it at a pretax profit of $330,000 in year 10.
For each of the project, what is:
1. the Payback Period?
2. the Net Present Value (NPV)?
3. the Profitability Index (PI)?
4. the Internal Rate of Return (IRR)?
5. the Modified Internal Rate of Return (MIRR)?