Exotic Food food processing company is considering adding a new division to produce fresh ginger juice. Following the ongoing TV buzz about significant health benefits derived from ginger consumption, the managers believe this drink will be a hit. However, the CEO questions the profitability of the venture given the high costs involved. To address his concerns, you have been asked to evaluate the project using two capital budgeting techniques (NPV & IRR) and present your findings in a report.
CASE OVERVIEW
The main equipment required is a commercial food processor which cost $50,000. Shipping and installation cost of the of the processor from China is $10,000. The processor will be depreciated using under the MACRS system using the applicable depreciation rates are 33%, 45%, 15%, and 7% respectively. Production is estimated to last four years as the company plans to exit the market before intense competition sets in. The processor could be sold at $10,000 at the end of the project. Account receivables will increase by $10,000, inventories will increase by $5,000 and accounts payable by $5,000. The total net working capital required at the start will be recovered at the end of the project. The juice will be packaged in 20 oz containers and will sell for $2.00 at the start and this unit price will increase at 3% each year. The company expects to sell 30,000 units the first year. Sales are expected to increase by 5% annually. Variable cost of goods sold is expected to total 30% of dollar sales. Fixed costs is estimated at $4,000 per year.
Weighted Average Cost of Capital (WACC):
Exotic Food’s common stock is currently listed at $70 per share; new preferred stock sells for $80 per share and pays dividend of $5 per share. Last year, the company paid dividends of $3.00 per share for common stock which is expected to grow at a constant rate of 12%. The local bank is willing to finance the project at 14% annual interest. The company’s marginal tax rate is 40% The optimum target capital structure is:
Common equity = 50%
Preferred = 20%
Debt = 30%
Your main task is to calculate the project’s WACC, free cash flows, and evaluate the free cash flows using capital budgeting techniques. Answer all the following questions to help in your analysis:
Part A: WACC
a. Determine the cost of each capital component:
After –tax Cost of Debt: _________________________
Cost of Preferred: _____________________________________________
Cost of Common Stock: _________________________________________
Write the WACC formula:_________________________________________
Calculate WACC: ________________________________________
Part B: Capital Budgeting
1. What is the total equipment cost? ________________________________
2. What is the Net Working Capital?
3. What is the total investment amount at the start of the project?
4. What is the depreciation amount and book values for each year?
Year 1 Year 2 Year 3 Year 4
a. Depreciation
b. Book Values
5. Calculate the after-tax salvage value
a. Write the after-tax salvage value:_______________________________________________
b. Calculate the after-tax salvage value:
6. Calculate the Net Income during the project’s life for each year.
You must list all the accounts and entries in order to earn full credit. No credit will be awarded for merely listing numbers without the associated accounts. Show the work in order to full credit
List the accounts Year 1 Year 2 Year 3 Year 4
7. Calculate the Operating Cash Flows (OCF) for each year.
List the accounts Year 1 Year 2 Year 3 Year 4
8. Create the projected Free Cash Flow (FCF) Schedule for the project:
List accounts Year 0 Year 1 Year 2 Year 3 Year 4
Free Cash Flows
9. Calculate the Net Present Value (NPV) using cash flow keys. List the steps.
10. Based on the NPV, should the project be accepted or rejected? Explain
11. Calculate the Internal Rate of Return (IRR) using cash flow keys. List the steps.
12. Based on the IRR, should the project be accepted or rejected. Explain
13. In your own words, present the project to the owners.
14. Why is capital budgeting very important to a company? Fully explain
15. Why is using an accurate WACC important project evaluation ? Fully explain
Part C: Bond & Stock Valuation
1. Hillard Manufacturing Inc. issued 15-year maturity coupon bonds when the market interest rate was 11%. If the coupon rate is 5% and the Par Value (Face Value) is $1,000, at what price will the bonds sell?
N I/Y PV PMT FV
2. Thomas Brothers is expected to pay a $0.90 per share dividend at the end of the year. The dividend is expected to grow at a constant rate of 8% a year. The required rate of return on the stock, rs , is 13%. What is the stock’s current value per share?
a. What is the stock’s intrinsic value?
b. What is difference between an overvalued versus undervalue stock?
3. What is a bond? Why is it important to business.
3b. Arnot International’s bonds have a current market price of $2,500. The bonds have an 10% annual coupon payment and 11 years left until maturity. What is the bond’s yield to maturity?
N I/Y PV PMT FV
Part D: Time Value of Money
1. Larry just won the lottery and must choose between three award options. He can elect to receive a lump sum today of $60 million, 12 end-of-year payments of $7million or 15 end-of-year payments of $3m. If he can earn 10% annually, what is the best option?
Hint: Compare apples to apples, and oranges to oranges.
a. To answer the question what must you solve for?
b. Clearly show all the calculations using a financial calculator. Clearly list the calculator keys and entries.
Financial Calculator solution:
c. Which option is best? Explain
2. Construct an amortization schedule for a $20,000 car loan at 6% to be repaid in 5 years. Assume annual payments.
Note: Ensure to list all headings. No points will be awarded for merely listing answers. No exceptions. You are required to show all work.
Question #3:
Note: Show all calculations. No points will be awarded for merely listing answers.
a. What is the annual payment amount?
N = I/Y = PV = PMT = FV =
b. Create a table, list the six headings and do the amortization.
c. What is the total amount of payments made during the life of the loan?
d. What is the total interest paid during the life of the loan?
e. Why is the total payment different from the total interest?
f. What is the importance of understanding a loan amortization? How can the knowledge be applied in making personal financial decision?