In the fall of 2009 Pearson Electronics, which manufactures printed circuit board used in a wide variety of applications ranging from automobiles to washing machines, was considering whether or not to invest in two major projects. The first was a new fabricating plant in Omaha, Nebraska, which would replace a smaller operation in Charleston, South Carolina. The plant would cost $50 million to build and incorporate the most modern fabricating and assembly equipment available. The alternative investment involved expanding the old Charleston plant so that it could match the capacity of the Omaha plant and modernizing some of the handling equipment at a cost of $30 million. Given the location of the Charleston plant, however, it would not be possible to completely modernize the plant due to space limitations. The end result, then, is that the Charleston modernization alternative cannot match the out-of -pocket operating costs per unit of the fully modernized Omaha alternative.
Pearson's senior financial analyst, Shirley Davies, made extensive forecasts of the cash flows for both alternatives but was puzzling over what discount rate or rates she should use to evaluate them. The firm's WACC was estimated to be 9.12%, based on an estimated cost of equity capital 12% and an after-tax cost of debt capital of 4.8%. However, this calculation reflected a debt to value ratio of 40% for the first, which she felt was unrealistic for the two plant investment. In fact, conversations with the firm's investment banker indicate that Pearson might be able to borrow as much as $12 million to finance the new plant in Omaha but no more than $5 million to fund the modernization and expansion of the Charleston plant without jeopardizing the firms current debt rating. Although it was not completely clear what was driving the differences in the borrowing capacities of the two plants, Shirley suspected that a major fact was the fact that the Omaha plant was more cost effective an offered the prospect of much higher has flows.
Answer the following questions:
A) Assuming that the investment banker is correct, use book value weight to estimate the project-specific cost of capital for the two projects (Hint: the only difference in the WACC calculations relates to the debt capacities for the two projects).
B) How would your analysis of the project-specific WACC be affected in Person's CEO decided to de-lever the first my using equity to finance the better of the two alternatives (i.e. the new Omaha plant of the Charleston plant expansion)?
The problem set deals with determining whether to utilize debt or equity financing for a set of projects.