Bob is evaluating the merits of a potential investment in adrone manufacturing company. He already owns the land for thefacility, but he would need to purchase and install the assemblymachinery for $240,000. The machine falls into the MACRS 5-yearclass, and it will cost $20,000 to modify it for Bob's particularneeds. A consultant, who charged Bob's $10,000 for his services,already completed the process of restructuring the facility for therequired zoning and industry standards. The facility requireadditional net working capital of $5,000. Drone sales are expectedto yield before tac revenues of $450,000 per year with labor costsof $200,000 per year and fixed costs of $175,000 per year. Bobexpects the machine to be used for 5 years and then sold for$55,000.
Bob has asked you to evaluate his proposed project, and he hasprovided you with the following information about theinvestment.
Bob's firm has a target capital structure of 25% debt, 5%preferred stock, and 70% common equity. Its bonds have a 9% coupon,paid semiannually, a current mature of 20 years, and sell at parfor $1,000. The firm could sell, at par, $100 preferred stock thatpays a 5.75% annual dividend, but flotation costs of 4% would beincurred. The firm's beta is 1.25, the risk-free rate is 3%, andthe expected rate of return on the market portfolio is 9.4%. Thecompany is a constant growth firm that just paid a dividend of$2.00, sells for $30 per share, and has a growth rate of 5%. Thefirm's policy is to use a risk premium of 4% when using thebond-yield-plus-risk-premium method to find the cost of equity. Thefirm's marginal tax rate is 42%.
In addition to finding the firm's average-risk cost of capital,Bob has also asked you to calculate a risk-adjusted cost ofcapital. He believes that the project's cash flows for years 1through 5 will increase by 10% in particularly good market, and thecash flows will decrease by 10% in a particularly bad market. Heestimates that there is a 15% probability of a good marketoccurring, a 25% probability of a bad market occurring, and a 60%probability of an "average" market occurring.
To complete this task of calculating a risk-adjusted cost ofcapital, you will need to find the expected NPV, its standarddeviation, and its coefficient of variation (CV). Bob informs youthat his average project has a CV in the range of 1.0 to 2.0. Ifthe CV of a project being evaluated is greater than 2.0, 2percentage points are added to the cost of capital for theevaluation. Similarly, if the CV is less than 1.0, 1 percentagepoint is deducted from the cost of capital for the evaluation.
In the end, Bob wants to know whether to accept or reject theproject. He expects you to make your conclusion using 3 techniques:discounted payback method, NPV analysis, and IRR analysis.
Throughout your analysis, you are to be as thorough as possible,documenting all of your work to support your conclusion. Pleaseshow the following calculations:
1) Bob's WACC for an average-risk project
2) Annual cash flow estimates for the project (including theinitial outlay)
3) A Risk- adjusted cost of capital for this project
4) An accept/reject decision based on the above 3 techniques
