Company Background

Dothraki Industries was established in the early 1980s for the purpose of manufacturing and forging high quality Valyrian steel products with a specialized niche in the production of custom forgings for the agricultural, construction, and defense industries. Dothraki has the advantage of in-house forging and heat-treating departments, which allowed Dothraki to develop a variety of innovative forged products. Within a few years, the company was distributing forged products across the world.

Proposal

The proposal involves investment in a group of machines that would greatly increase the firm's ability to manufacture large quantities of swords. The purchase price of this machinery would be $60,000,000. The steel sword equipment would have a useful economic life of 3 years, but for tax purposes, depreciation charges would be straight-line to a book value of zero over 4 years (25% each year). The expected revenue projections from this project are $100,000,000 in each year of the project (years 1, 2, and 3), and it is anticipated that the variable operating costs, excluding depreciation, will be approximately 70 percent of sales. Interest charges associated with the financing of this investment have been estimated at approximately $3,000,000 per year, for each year of the projects estimated useful life.

Sam Tarley, the firms accountant, pointed out that this project would not be happening if not for the special feasibility study performed by the Stark Consulting Group. The study was commissioned and paid for last year at a total cost of $2,500,000.

In addition to the initial outlay for the machinery, the firm anticipates that it will have to make incremental working capital investments to parallel the expected changes in sales. Based on financial analysis, it has been agreed that an appropriate estimate of a proper working capital requirement figure would be 10 percent of incremental sales (i.e., the NWC investment (or recovery) at time t will be 10% of the change in sales between time t, and t + 1). Management expects the machinery to be sold for a before-tax scrap value of $5,000,000 at the end of year 3. The expected revenue projections from this project are $100,000,000 in each year of the project.

The CFO of Dothraki Industries, Peter Baelish, requests your assistance in preparing an analysis of the decision of whether or not to purchase the machine. In performing the analysis, Mr. Baelish would like to see estimates of net cash flow projections for the project, along with the NPV and your recommendation. As part of the analysis, Mr. Baelish has informed you that he believes that the risk of this project is of similar risk as the average risk for the firm and therefore you may use the firms Weighted Average Cost of Capital (WACC) as the appropriate discount rate. He has also informed you that the tax rate to use for the WACC and the capital budgeting analysis is 25%. Finally, he believes that there will be sufficient taxable income annually from other Dothraki projects to be able to use any tax losses or credits from the project.

Capital Structure Information

Dothraki has 6,000,000 shares of common stock outstanding that are trading for $25 per share. The companys beta is 1.2. Financial analysts estimate that the market risk premium over 10-year Treasury Bonds is 6 percent and 10-year Treasury Bonds currently yield 4%. Dothrakis outstanding bonds have a 7.0% coupon rate, a $1,000 face value, pay semi-annual coupons, and mature in 10 years. There are 96,000 of these bonds outstanding and they are currently selling in the open market for 102.5% of par or face value.

1. What is the cost of equity for the firm for this project? (provide your answer in decimals with two places, e.g., 12% would be 0.1200)
2. What is the before tax cost of debt for the firm for this project?
3. What is Dothraki's WACC for this project?
4. What is the OCF for year 2 of the project?
5. What is the cash flow from CAPEX/Capital Spending at the end of the project (the after-tax salvage value)?
6. What is the NPV of this project?
7. Would you recommend to Stark that Dothraki move forward with this project?