Finance - Capital Budgeting

Capital Budgeting

Extra Inc. is considering an investment in a new $35M power supply project. The project's cost will be depreciated evenly over its 5 year life and have a salvage value of $3.5M. At the end of five years, the company would like to scrap the project and sell all related assets for 150 percent of its book value.

The company owns an existing facility that is expected to be fully incorporated into the new power supply project. The facility was purchased 10 years ago for $3.75M, but was refurbished two years ago at a price of $2.5M and then appraised at $4.5M. A comparable facility recently sold for $5.25M after taxes. It is anticipated that the facility can be sold for $7.5M in five years after taxes and reclamation costs.

The project is expected to generate 1,000,000 units of power supply in its first year of operation at a cost of $18.50 per unit and the firm expects to realize a selling price of $25.00 per unit. The associated fixed costs are $1.25M up to a capacity of 2,500,000 units of power supply. Fixed costs increases at a rate of 20% for each additional 2,500,000 units produced. The company expects to grow units of production by 50 percent per year until the end of the third year and by 25 percent for all remaining years.

The company expects to finance the $35M direct cost of the new power supply project in a manner that will preserve its current capital structure. The applicable interest expense from new debt financing is expected to be tax deductible. Net working capital required for the project is $875,000. Assume no immediate or future tax credits on negative earnings.

a. You have been hired as a financial consultant to Extra Inc. and have been asked to assess the financial merits of the projected. Find NPV, IRR, MIRR, PI, AAR, PB, DBP and based on your analysis, should the firm proceed with the project? (A payback period of 4 years is deemed reasonable to the firm).

b. Given recent concerns about this form of power supply, management is unsure about its initial units of production projection, the expected selling price, and the cost per unit of production. You have been asked to conduct a Best and Worst Case Scenario analysis using +/- 5% for these inputs. Based upon your analysis, should the company move forward with the project?

c. Which of variables from part(b) is the project's NPV most sensitive to: units of production, selling price, or production cost? What is the degree of sensitivity to each variable? With this information, what might you suggest to management?

Assume:
1) Capital Structure mix
Bond 1 20.09%
Bond 2 29.53%
Common Equity 41.72%
Preferred Stock 8.66%
Total 100.00%

2)
Bond 1 Bond 2

Coupon Rate (Semi-annual) 7.00% 0.00%
Time to Maturity 7.5 yrs 13 yrs
Market Price 101.50% 24.86%
# of Bonds 50,000 300,000

3) WACC 8.667%
Tax rate 25%