The interest rate on the 20-year Government of Canada bond is currently 3.00% and the market risk premium is 5.60%. MDFA has a marginal tax rate of 25.0% and a debt-to-total capitalization ratio of 30.0% which approximates the companys target capital structure.

1.

Calculate the WACC for each of the two projects.

2.

Calculate the cash flows for each year, from 0 (initial investment) to 10 or 15 (depending on the project).

a.

Do an income statement and add back depreciation to calculate the CF:

b.

Don't forget the inventory needs at the beginning as part of the initial cash flows.

c.

Remember tax effects at the end of the project as a result of the disposals.

d.

Note: you don't subtract interest from any cash flows because interest costs are considered in the WACC. So "incremental net income" = EBIT(1-T)

3.

Calculate the NPV

NPV = sum of the present values of the cash flows for this project

Ventilation Division: Industrial Air Filtration System (IAFS) Projections The Ventilation Division will manufacture the IAFS using idle facilities. This plant can produce up to 260 units per year over the product's 10-year life. An outside appraiser indicated that the plant is worth $3,000,000, which breaks down as $1,400,000 for the land and $1,600,000 for the building. New production equipment costing $5,800,000 is also required. It is believed that the land will have a residual value of $1,800,000 at the end of the project's life, while the building and equipment will be worth $500,000 and $250,000. The building is subject to a CCA rate of 4.0% and the equipment is subject to a CCA rate of 20.0%. Incremental net working capital of $600,000 is also needed which will be liquidated at the end of the product's life. IAFS sales are estimated to be 70 units in the first year and will grow by 25.0% a year until plant capacity is reached. The unit price is $120,000 and unit costs are $100,000 per unit, which includes direct materials, direct labour, and manufacturing overhead. The Ventilation Division must also pay a $10,000 licensing fee per unit for the vacuum cleaner technology. Incremental selling and administration costs will be $350,000 per year. Automated Paving Stone Installer (APSI) Projections A new factory is needed to manufacture the APSI. The facility can produce up to 300 machines each year over the product's 15-year life. A parcel of land worth $400,000 will be purchased, and a building constructed for $1,800,000. Equipment costing $3,500,000 is also be required. At the end of the project's life, it is estimated the land can be sold for $780,000, while the building will have a residual value of $620,000 and the equipment's residual value will be negligible (i.e., zero). Building and equipment costs are subject to CCA rates of 4.0% and 20.0% respectfully. An investment of $370,000 in net working capital is needed to support production that will be liquidated at the end of the product's life. APSI sales are forecasted to be 100 units in the first year, 150 in the second year, 200 in the third year, 250 in the fourth year, and then reach factory capacity of 300 units in the fifth year. The product's list price is $350,000 and its unit cost is $340,000, which includes direct materials, direct labour and factory overhead. Incremental selling and administration costs to support the business will be $1,600,000. Existing corporate overhead of $230,000 per year will be allocated to the product as per company policy. Factory equipment will be overhauled at a cost of $1,500,000 at the end of year 8 . Discount Rate In the past, MDFA used a corporate cost of capital to evaluate the feasibility of its new product proposals. Denison felt this rate was inaccurate as it reflected the weighted-average cost of capital of the three MDFA divisions. The Ventilation Division likely has a higher cost of capital Page 2 since its products are sold primarily to private-sector companies with greater exposure to the business cycle. In comparison, the Surfaces Division likely has a lower cost of capital as it sells its products primarily to city and municipal governments with relatively stable tax revenues and public works budgets. To be more precise, Denison decided to use divisional costs of capital to evaluate each project. To determine the cost of capital for the Ventilation Division, Denison collected information on the betas and credit spread on Treasuries for five public companies in the industry: For the Surfaces Division, MDFA only has one publicly-traded North American company for comparison. Dura Surface Ltd. has been in existence for 30 years selling road and sidewalk surfacing machinery. Exhibit 1 provides share prices for Dura Surface and national stock index values for the last five years. Dura Surface issues bonds to finance its operations, which currently trade at $998.57 with a par value of $1000 and have a coupon rate of 5.01% and a term of 12 years with a semiannual payment. Exhibit 1: Market Return Data Ventilation Division: Industrial Air Filtration System (IAFS) Projections The Ventilation Division will manufacture the IAFS using idle facilities. This plant can produce up to 260 units per year over the product's 10-year life. An outside appraiser indicated that the plant is worth $3,000,000, which breaks down as $1,400,000 for the land and $1,600,000 for the building. New production equipment costing $5,800,000 is also required. It is believed that the land will have a residual value of $1,800,000 at the end of the project's life, while the building and equipment will be worth $500,000 and $250,000. The building is subject to a CCA rate of 4.0% and the equipment is subject to a CCA rate of 20.0%. Incremental net working capital of $600,000 is also needed which will be liquidated at the end of the product's life. IAFS sales are estimated to be 70 units in the first year and will grow by 25.0% a year until plant capacity is reached. The unit price is $120,000 and unit costs are $100,000 per unit, which includes direct materials, direct labour, and manufacturing overhead. The Ventilation Division must also pay a $10,000 licensing fee per unit for the vacuum cleaner technology. Incremental selling and administration costs will be $350,000 per year. Automated Paving Stone Installer (APSI) Projections A new factory is needed to manufacture the APSI. The facility can produce up to 300 machines each year over the product's 15-year life. A parcel of land worth $400,000 will be purchased, and a building constructed for $1,800,000. Equipment costing $3,500,000 is also be required. At the end of the project's life, it is estimated the land can be sold for $780,000, while the building will have a residual value of $620,000 and the equipment's residual value will be negligible (i.e., zero). Building and equipment costs are subject to CCA rates of 4.0% and 20.0% respectfully. An investment of $370,000 in net working capital is needed to support production that will be liquidated at the end of the product's life. APSI sales are forecasted to be 100 units in the first year, 150 in the second year, 200 in the third year, 250 in the fourth year, and then reach factory capacity of 300 units in the fifth year. The product's list price is $350,000 and its unit cost is $340,000, which includes direct materials, direct labour and factory overhead. Incremental selling and administration costs to support the business will be $1,600,000. Existing corporate overhead of $230,000 per year will be allocated to the product as per company policy. Factory equipment will be overhauled at a cost of $1,500,000 at the end of year 8 . Discount Rate In the past, MDFA used a corporate cost of capital to evaluate the feasibility of its new product proposals. Denison felt this rate was inaccurate as it reflected the weighted-average cost of capital of the three MDFA divisions. The Ventilation Division likely has a higher cost of capital Page 2 since its products are sold primarily to private-sector companies with greater exposure to the business cycle. In comparison, the Surfaces Division likely has a lower cost of capital as it sells its products primarily to city and municipal governments with relatively stable tax revenues and public works budgets. To be more precise, Denison decided to use divisional costs of capital to evaluate each project. To determine the cost of capital for the Ventilation Division, Denison collected information on the betas and credit spread on Treasuries for five public companies in the industry: For the Surfaces Division, MDFA only has one publicly-traded North American company for comparison. Dura Surface Ltd. has been in existence for 30 years selling road and sidewalk surfacing machinery. Exhibit 1 provides share prices for Dura Surface and national stock index values for the last five years. Dura Surface issues bonds to finance its operations, which currently trade at $998.57 with a par value of $1000 and have a coupon rate of 5.01% and a term of 12 years with a semiannual payment. Exhibit 1: Market Return Data