Caspers is analyzing a proposed expansion project that is mu

Casper\'s is analyzing a proposed expansion project that is much riskier than the firm\'s current operations. Thus, the project will be assigned a discount rate equal to the firm\'s cost of capital plus 3 percent. The proposed project has an initial cost of $17.2 million that will be depreciated on a straight-line basis over 20 years. The project also requires additional inventory of $687,000 over the project\'s life. Management estimates the facility will generate cash inflows of $2.78 million a year over its 20-year life. After 20 years, the company plans to sell the facility for an estimated $1.3 million. The company has 60,000 shares of common stock outstanding at a market price of $49 a share. This stock just paid an annual dividend of $1.84 a share. The dividend is expected to increase by 3.5 percent annually. The firm also has 10,000 shares of 12 percent preferred stock with a market value of $98 a share. The preferred stock has a par value of $100. The company has a 9 percent, semiannual coupon bond issue outstanding with a total face value of $1.1 million. The bonds are currently priced at 102 percent of face value and mature in 16 years. The tax rate is 33 percent. Should the firm pursue the expansion project at this point in time? Why or why not? O Reject; the NPV is-$3.027 million. Accept the NPV is $4.507 million O Reject: the NPV is-$3.241 million. O Accept; the NPV is $2.648 million O Reject; the NPV is $1.040 million.

Solution

Initial investment = cost of facility + net working capital

Initial investment = 17,200,000 + 687,000 = $17,887,000

Annual depreciation = 17,200,000 / 20 = 860,000

Operating cash inflows from year 1 to 20 = 2,780,000

Non operating cash flow in year 20 = salvage value + net working capital - tax( salvage value - book value)

Non operating cash flow in year 20 = 1,300,000 + 687,000 - 0.33 ( 1,300,000 - 0)

Non operating cash flow in year 20 = $1,558,000

Cost of equity = (D1 / share price) + growth rate

Cost of equity = [( 1.84 ( 1.035) / 49] + 0.035

Cost of equity = 0.073865 or 7.3865%

Cost of preferred shares = Annual dividend / preference share price

Annual dividend = 0.12 * 100 = 12

Cost of preferred shares = 12 / 98

Cost of preferred shares = 0.122449 or 12.2449%

Price of bond = 102% of 1,100,000 = $1,122,000

Number of periods = 16 * 2 = 32

Coupon payment = 0.09 * 1,100,000 = 99,000 / 2 = 49,500

Before tax cost of debt using financial calculator = 8.7652%

Keys to use in a financial calculator: PV = -1,122,000, FV = 1,100,000, N = 32, PMT = 49,500, CPT I/Y

After tax cost of debt = 0.087652 ( 1 - 0.33)

After tax cost of debt = 0.058727 or 5.8727%

Market value of common stock = 60,000 * 49 = 2,940,000

market value of preferred stock = 10,000 * 98 = 980,000

Market value of debt = 1,122,000

Toal market value of capital structure = 2,940,000 + 980,000 + 1,122,000 = 5,042,000

Weight of common stock = 2,940,000 / 5,042,000 = 0.5831

Weight of preferred stock = 980,000 / 5,042,000 = 0.1944

Weight of debt = 1,122,000 / 5,042,000 = 0.2225

WACC = weight of common stock * cost of common stock + weight of preferred stock * cost of preferred stock + weight of debt * cost of debt

WACC = 0.5831 * 0.073865 +  0.1944 * 0.122449 + 0.2225 * 0.058727

WACC = 0.043071 + 0.023804 + 0.013067

WACC = 0.079942 or 7.9942%

Project\'s cost of capital = 7.9942 + 3 = 10.9942%

Present value of operating cash flows = Annuity * [ 1 - 1 / ( 1 + R)ⁿ] / R

Present value of operating cash flows = 2,780,000 * [ 1 - 1 / ( 1 + 0.109942)²⁰] / 0.109942

Present value of operating cash flows = 2,780,000 * 7.96635

Present value of operating cash flows = $22,146,451.71

Present value of non operating cash flow = 1,558,000 / ( 1 + 0.109942)²⁰

Present value of non operating cash flow = $193,446.8876

NPV = Present value of cash inflows - present value of cash outflows

NPV = 22,146,451.71 + 193,446.8876 - 17,887,000

NPV = 4.507 million

Accept, the NPV is $4.507 million