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?
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, B_{L} = 0.5; Average debt-equity ratio = D / E = 2 / 3, Tax rate, T = 40%
Hence, unlevered beta, B_{U} =B_{L} / [1 + (1 - T) x D / E] = 0.5 / [ 1 + (1 - 40%) x 2 / 3] = 0.3571
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:
Hence, for the alcohol distribution division, D / E = 5 / (20 - 5) = 5 / 15 = 1 / 3
Hence, levered beta for this division, B_{L} = B_{U} 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 + B_{L} 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%
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:
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:
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... |
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