Worldwide Medical Devices (WMD) manufactures medical diagnostic equipment at several locations across Europe. WMD has traditionally manufactured large high-quality medical equipment for use in hospitals. Recently, the firm has developed a new technology that makes testing vitamin D deficiency at GP surgeries an affordable possibility, which avoids the need to send patients’ blood to testing laboratories. WMD has spent €50m designing and developing this new generation of equipment for the European domestic market. The costs to complete the final stages of regulatory approval are estimated to be €30m. WMD plan to establish a new division, Fast Medical Diagnostics (FMD), to manufacture and market this new generation of testing devices. This will be WMD’s first venture into the smaller equipment market. WMD will continue to manufacture its larger hospital equipment separately.
This new generation of testing devices is expected to have a production life of six years. The group finance director is busy arranging a new debt facility for WMD and has asked you to prepare an investment appraisal report to present to the next board meeting, which will make a recommendation to the directors as to whether to proceed with establishing FMD.
The new FMD factory would be built on a vacant site already owned by WMD, which is adjacent to their existing factory in Lyon. The vacant site was recently valued at €6m. Investment to build the factory and the required plant and equipment would be €300m. WMD charges depreciation on a straight-line basis over the useful life of assets. The plant and equipment is not expected to have any scrap value at the end of the project. The project will also require additional working capital of €60m for the life of the project. It is expected that 60% of the working capital investment will be recovered at the end of the project.
Currently, net investment in plant and equipment is eligible for capital allowances on a straight-line basis over four years. The applicable corporation tax rate is 30%, paid one year in arrears. Capital allowances are received by WMD in the same year that they are claimed.
FMD expects to sell a total of 100,000 of the devices each year at a fixed price of €3200 per device over the planned production life of six years. Incremental operating costs for FMD are estimated to be €220m per annum. All cash flows are in today’s money and inflation is expected to be 2.5% per annum over the next six years.
WMD’s shares continue to be listed on the Paris Stock Exchange, where they currently trade at €3.5 with an equity beta of 1.6. The expected equity risk premium is 8% and risk-free rate is 2%. WMD currently has a market gearing ratio (debt/(debt+equity)) of 30%. WMD has sufficient resources available to fund the FMD project from current facilities. The current average before-tax cost of borrowing for the company is 5%.
You are required to:
a. Estimate the weighted average cost of capital (WACC) for WMD.
b. Carry out a discounted cash flow (DCF) analysis of the project based on the information given and calculate the net present value (NPV), internal rate of return (IRR) and payback period of the project using both simple payback and discounted payback. Discuss and justify your chosen discount rate. If the discount rate you use in your DCF analysis differs from the WACC estimated in part (a), explain why.
Give the group finance director a clear recommendation whether you think WMD should proceed with the FMD project. Explain the reasoning behind your decision. Also mention any reasons for excluding any of the information given above and explain any additional assumptions you have made while making your calculations.
c. The new debt facility currently under negotiation would provide WMD with additional funds to pay for a whole new series of projects and product upgrades. The new capital structure will result in WMD’s market gearing ratio (debt/(debt+equity)) increasing to 50%.
Estimate a new WACC for WMD. Does this change your choice of discount rate from that you used in the DCF analysis in part (b)? Recalculate your NPV for the project. Does this change your previous recommendation? Explain why.