menu
bartleby
search
close search
Hit Return to see all results

Question 4 You are Chief Financial Officer of the ABC Corporation. ABC has two divisions, one of which distributes alcohol, while the other manufactures bottles for brewers and beverage companies. The company is considering a capacity expansion project in the alcohol distribution division, and the Board of Directors has asked you to provide a financial analysis of the project.• The project would require an initial investment of $100 million for a new distribution center. In addition, $20 million in additional working capital would need to be committed to the project. The working capital will be recovered at the end of the project life. • The distribution center facilities would be depreciated on a straight-line basis over five years. At the end of five years, you estimate that the center will be sold for $20 million. • The distribution center is expected to generate cash revenues of $85 million per year and cash operating costs of $50 million per year in each of the next five years. • The corporate tax rate is 40%. • The book value of ABC’s assets is $20 billion, while the book value of its outstanding debt is $5 billion. ABC’s equity has an estimated beta of 1.2. • The expected return on the market portfolio is 15%, while the risk-free rate of return is 5%. • ABC could issue new debt at a yield to maturity of 8%. • Companies that operate purely in the bottle manufacturing industry have an average beta of 1.5 and an average debt-equity ratio (measured at market value) of one quarter. • Companies that operate purely in the alcohol distribution industry have an average beta of 0.5 and an average debt-equity ratio (measured at market value) of two-thirds. Based on information above, you are to complete the project analysis to present the Board meeting that is scheduled tomorrow.a) Calculate the weighted average cost of capital. b) Calculate the free cash flow of each year for the expansion project. c) What is the NPV for the project?

Question

Question 4

You are Chief Financial Officer of the ABC Corporation. ABC has two divisions, one of which distributes alcohol, while the other manufactures bottles for brewers and beverage companies. The company is considering a capacity expansion project in the alcohol distribution division, and the Board of Directors has asked you to provide a financial analysis of the project.

• The project would require an initial investment of $100 million for a new distribution center. In addition, $20 million in additional working capital would need to be committed to the project. The working capital will be recovered at the end of the project life.

 

• The distribution center facilities would be depreciated on a straight-line basis over five years. At the end of five years, you estimate that the center will be sold for $20 million.

 

• The distribution center is expected to generate cash revenues of $85 million per year and cash operating costs of $50 million per year in each of the next five years.

 

• The corporate tax rate is 40%.

 

• The book value of ABC’s assets is $20 billion, while the book value of its outstanding debt is $5 billion. ABC’s equity has an estimated beta of 1.2.

 

• The expected return on the market portfolio is 15%, while the risk-free rate of return is 5%.

 

• ABC could issue new debt at a yield to maturity of 8%.

 

• Companies that operate purely in the bottle manufacturing industry have an average beta of 1.5 and an average debt-equity ratio (measured at market value) of one quarter.

 

• Companies that operate purely in the alcohol distribution industry have an average beta of 0.5 and an average debt-equity ratio (measured at market value) of two-thirds.

 

Based on information above, you are to complete the project analysis to present the Board meeting that is scheduled tomorrow.

a) Calculate the weighted average cost of capital.

 

b) Calculate the free cash flow of each year for the expansion project.

 

c) What is the NPV for the project?

check_circleAnswer
Step 1

All financial figures appearing in this solution are in $ mn unless otherwise stated.

a) Calculate the weighted average cost of capital.

Companies that operate purely in the alcohol distribution industry have an average beta of 0.5 and an average debt-equity ratio (measured at market value) of two-thirds.

Levered beta of the industry, BL = 0.5; Average debt-equity ratio = D / E = 2 / 3, Tax rate, T = 40%

Hence, unlevered beta, BU =BL / [1 + (1 - T) x D / E] = 0.5 / [ 1 + (1 - 40%) x 2 / 3] = 0.3571 

Step 2

We will have to relever this beta using debt equity ratio of the alcohol distribution division.

We don't have information pertaining to the capital structure of this division. However, we have information about the capital structure of the entire firm.

The book value of ABC’s assets is $20 billion, while the book value of its outstanding debt is $5 billion.

Two assumptions are necessitated at this stage:

  • In the absence of division specific capital structure, we assume the capital structure for the alcohol distribution division will be same as that for the firm.
  • In the absence of information the market value of the assets, debt & equity, we assume that the market values are same as their respective book values.

Hence, for the alcohol distribution division, D / E = 5 / (20 - 5) = 5 / 15 = 1 / 3

Hence, levered beta for this division, BL = BU x [1 + (1 - T) x D / E] = 0.3571 x [1 + (1 - 40%) x 1 / 3} = 0.4286 

Hence cost of equity, Ke = Risk free rate + BL x (Return from market - RIsk free rate) = 5% + 0.4286 x (15% - 5%) = 9.29%

Pre tax cost of debt, Kd = YTM of new debt = 8%

Hence, WACC = R = D / (D + E) x Kd x (1 - T) + E / (D + E) x Ke = 5 / 20 x 8% x (1 - 40%) + 15 / 20 x 9.29% = 7.79%

Step 3

Part (b) Calculate the free cash flow of each year for the expansion project.

All financials figures are in $ mn

Initial investemnt, C0 = initial investment + additional working capital = 100 + 20 = 120

Annual post tax operating cash flow:

  • Cash revenue = 85
  • Cash expenses = 50
  • Annual depreciation = Initial investment / Life = 100 / 5 = 20
  • NOPAT = (Cash revenue - Cash expenses - Annual depreciation) x (1 - T) = (85 - 50 - 20) x (1 - 40%) = 9

Hence, post tax annual operating cash flow = C = NOPAT + Depreciation = 9 + 20 = 29 at the end of each year from T = 1 through T = 5

Terminal cash flows:

  • Post tax salvage value = Salvage value x (1 - T) = 20 x (1 - 40%)  = 12
  • Release of working capital = 20

Hence, terminal cash flows, CT = 12 + 20 = 32 at the end of year 5

Hence, the free cash flow of each year for the expansion project is summarised below:

Year

0

1

2

3

4

5

Initial investment

-120

     

[+] Post tax annual operating cash flows

 

29

29

29

29

29

[+] Terminal cash flows

     

32

Free Cash flows

-120

29...

Want to see the full answer?

See Solution

Check out a sample Q&A here.

Want to see this answer and more?

Our solutions are written by experts, many with advanced degrees, and available 24/7

See Solution
Tagged in

Business

Finance

Capital Budgeting

Related Finance Q&A

Find answers to questions asked by student like you

Show more Q&A add
question_answer

Q: Simone's Sweets is an all-equity firm that has 9,100 shares of stock outstanding at a market price o...

A: As is situation: All equity, no debt, hence no interest payment, Let T be the tax rate.Hence, Pre ta...

question_answer

Q: Micro-Technologies is a Bio Tech research firm that is conducting research on a cure for Aids. Their...

A: Step1: Calculating the value of after-tax cash outflow under lease arrangement. We have,Lease paymen...

question_answer

Q: Now assume that the additional patients will add $200,000 in total to theCenter’s fixed costs. Now w...

A: Incremental Profit = Incremental profit in ealrier case - incremental fixed cost = $ 1,680,887  - $ ...

question_answer

Q: Block, S., Hirt, G., & Danielsen, B. (2017). Foundations of Financial Management. New York, NY: ...

A: Sale Price per bag, SP = $ 20 / bag; Variable cost per bag, VC  = variable cost per pound x no. of p...

question_answer

Q: A firm with sales of $500,000 has average inventory of $200,000. T he industry average for inventory...

A: Computation of inventory turnover:

question_answer

Q: A 10-year bond has a coupon rate of 11%, a par value of $1000. If the bond’s YTM is 7%, what is the ...

A: Assume semi annual coupon bond (Such an assumption is customary to bonds in US market). This means c...

question_answer

Q: If Wild Widgets, Inc., were an all-equity company, it would have a beta of .90. The company has a ta...

A: Cost of Debt:Cost of Debt is the amount or rate which a company bears on the borrowings. It also sta...

question_answer

Q: You have $5,000 invested in a bank account that pays a 6percent nominal annual interest with daily c...

A: Amount invested, PV = $ 5,000Interest rate = 6% annual interest rate compounded daily.Hence, interes...

question_answer

Q: PC Shopping Network may upgrade its modem pool. It last upgraded 2 years ago, when it spent $100 mil...

A: Net cash flow: The difference between the company’s inflow and outflow of cash calculated for a give...

Sorry about that. What wasn’t helpful?