Instructions:
Using the company information provided below, complete the following two tabs in this MS Excel Workbook:
– Computation of the company’s estimated cost of equity capital, rE, and weighted average cost of capital, rWACC
– NPV (capital budgeting) analysis of the company’s proposed investment in a new Product B
The background paper, Capital Budgeting and the Cost of Capital, provides useful guidance for completing this assignment.
Based on the results of your NVP Analysis, summarize your recommendations to management regarding its contemplated introduction of the new product. Limit the length of your response to 75 words.
Product line B should not be introduced because the NPV of the project is negative at $13629055. This means that the project is infeasible. The IRR of the project is at -2.5% which means that the project is bound to lose money if it is implimented. This is compounded by the fact that the project has a Profitability Index < 1. Hence taking these three metrics together, the analysis is clearly in favour of rejecting the company’s proposal to launch Product B
Company information:
North American Manufacturing Company is a U.S.-based publicly traded company, whose stock is listed on a national securities exchange.
Management looked up the stock’s historical β (beta) at a popular financial Web search engine and obtained this additional information:
| Historical β (beta) of the company’s common stock | 1.20 | |
| Historical β (beta) of the company’s common stock | 0.095 | (9.5percent) |
| Historical β (beta) of the company’s common stock | 0.400 | (40.0percent) |
| Historical β (beta) of the company’s common stock | 0.125 | (12.5 percent) |
| Historical β (beta) of the company’s common stock | 0.040 | (4.0 percent) |
| The balance sheet of the company as of its most recent fiscal year end reflects management’s targeted capital structure for the company. |
| That balance sheet reports the following liability and shareholders’ equity balances: |
| Notes payable to banks – current portion | $1,00,00,000 |
| Bonds payable – current portion | 6,50,00,000 |
| Notes payable to banks – noncurrent portion | 37,50,00,000 |
| Bonds payable – noncurrent portion | 15,00,00,000 |
| Common stock, at par | 3,00,00,000 |
| Additional paid-in capital | 28,50,00,000 |
| Treasury stock | (4,50,00,000) |
| Retained earnings | ########### |
| Cost of recently completed test-marketing of Product B | $2,20,000 | |
| Costs of previously incurred Product B research and development (R&D) costs | $30,00,000 | |
| Management’s estimate of the economic life of Product B | 5.0 | years |
| Cost of additional machinery and equipment (M&E) needed to manufacture Product B | $5,00,00,000 | |
| Fair value of vacant building owned, to be used as Product B manufacturing facility | $20,00,000 | (Note1) |
| Estimated residual (fair) value of M&E at end of investment (Product B’s economic life) | $1,25,60,000 |
Note 1 – The vacant building is fully depreciated; no significant changes in the value of building over Product B investment period expected
As such, the projected net proceeds from the assumed end-of-investment disposal of the building is $1,200,000 [i.e., $2.0 million x (1 – 0.40)]
Management’s projections:
| Probability-weighted expected sales of Product B: | YEAR 1 | YEAR 2 | YEAR 3 | YEAR 4 | YEAR 5 |
| Units | 33,00,000 | 36,00,000 | 35,00,000 | 34,00,000 | 32,00,000 |
| Revenue | ####### | $6,75,00,000 | ######## | ####### | ######## |
| Variable cost (VC) per unit | $7.00 | $7.30 | $7.70 | $8.00 | $8.30 |
| Incremental fixed costs (FC), other than depreciation of M&E | ####### | $1,57,20,000 | ####### | ####### | ######## |
| Erosion of existing Product A (contribution margin) (Note 2) | $56,00,000 | $55,00,000 | $54,00,000 | $51,00,000 | $42,00,000 |
| Required end-of-year balance of net working capital | $56,00,000 | $60,00,000 | $54,00,000 | $48,00,000 | $ – |
Note 2 – Projected adverse effects on the profitability of the company’s existing Product A, resulting from introduction of new Product B
| The facilitator will grade this assignment, assigning up to 100 points for it as follows: | Maximum | Earned |
| Accuracy, completeness, and clear presentation of: | ||
| – Business’ cost of capital, including related information input and computations | 25 | 25 POINTS |
| – Incremental cash flows attributable to proposed investment and capital budgeting analysis, including related information input and computations, and investment decision reached | 75 | 75 |
| Total points | 100 | 100 |
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