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Alpha Signmaking - WACC, RR, NPV

Alpha Signmaking, the leading producer of laminated sign making equipment, spent 2 years and $3 million dollars developing a new semiautomatic signmaker. In 1988, the company was ready to make a decision about placing the new signmaker into production. This signmaker would fill the gap between a manual unit selling for $1,000 and a fully automatic unit selling for $50,000. This signmaker would allow instant print shops to enter the sign business; they were presently shut out by the high labor costs of the manual unit and the high capital cost of the fully automatic unit. If someone else introduced the semiautomatic signmaker first, Alpha could lose its position of dominance in the business.

Managers at Alpha estimated that $10 million in capital investments would be needed to begin production of the new equipment. The capital equipment would have a 10-year use life and a 7-year tax life (Alpha would use straight-line depreciation). The capital investment would have no salvage value, and half of the net working capital would be recovered at the end of the project's life. Net working capital would be approximately 10% of annual sales. The equipment would be placed in service on January 1, and the working capital investment would be required almost immediately.

Alpha would price the new signmaker at $ 1 0,000, and anticipated selling 2,000 units a year. Fixed operating costs other than depreciation would be $5 million a year for the new signmaker, and variable costs would be 60% of the sale price. Half of Alpha's assets were typically funded with debt, and the interest rate was currently 10%, so Alpha would also have an interest expense of $600,000 a year.

Alpha Signmaking was a division of Alpha Laminating. Alpha Laminating's general approach to capital budgeting was to create an annual capital budget--$50 million for the current year--and then allocate the budget among competing proposals at an annual strategic planning conference. Analysts computed payback and accounting rate of return for each project. A project with a payback longer than 5 years could not be brought up for consideration, and a payback of 3 years was preferred. There had been some discussion of switching to an internal rate of return ranking procedure for allocating the capital budget.

Alpha Larninating had debt with a book value of $200 million, which carried an average interest rate of 8% and was currently trading at 90% of face value. This resulted in a yield to maturity of 10%. Treasury bills were currently providing a yield of 7%, and U.S. Government bonds were providing a yield of 9%. It was estimated that the average market risk premium for stocks in general was 6%. Alpha's common stock had a beta of 0.73. However, the signmaking division was more risky than some of the other operations because demand for signs fell sharply during business downturns. It was estimated that the signmaking division would have a beta of 1.4 if it were traded as an independent company. Because of Alpha's dominant position, its return on equity was well above the required return. Alpha had 10 million shares of common stock outstanding, and the stock had recently been trading in the $18 range. Like most corporations, Alpha paid a 34% marginal tax rate.

Two types of uncertainty worried managers at Alpha. First, there was the possibility that the equipment would be unsuccessful or uneconomical when full-scale production was tried. If this were the case, the investment would be abandoned within a few months. The capital equipment could be scrapped for approximately $500,000 in this case, and approximately half of the net working capital could be recovered. Obsolescence was the second risk. It was always possible that new technology would make a fully automated signmaker available in the $ 10,000 range in future years. This would certainly kill sales of the semiautomatic unit. The probability of technical problems was estimated at only 5%. It was difficult to estimate the probability of obsolescence, but production of low-priced automatic equipment within the next 5 years was extremely unlikely.

Questions
1. Compute the weighted average cost of capital for Alpha Laminating.
2. What is the appropriate required return for this project?
3. Assuming the project works out technologically and lasts 10 years, identify all relevant cash flows.
4. Based on the assumptions in #2, compute the net present value. (Assume year-end cash flows for simplicity.)
5. Considering the expected net present value, risks, and strategic implications involved, should Alpha invest in the new signmaking system?

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Questions
1. Compute the weighted average cost of capital for Alpha Laminating.

WACC is the weighted average cost of capital whereby the target proportions of debt and equity along with the component costs of capital are used to calculate.

Given:

Treasury bills were currently providing a yield of 7%
It was estimated that the average market risk premium for stocks in general was 6%. Therefore, the current expected rate of return on the market is 6% + 7% (risk premium + Krf)
Alpha's common stock had a beta of 0.73.
Alpha Larninating had debt with a book value of $200 million, which carried an average interest rate of 8% and was currently trading at 90% of face value. This resulted in a yield to maturity of 10%.
Alpha had 10 million shares of common stock outstanding, and the stock had recently been trading in the $18 range. Therefore, the total equity is $180 million.
Alpha paid a 34% marginal tax rate.

First, we have to find Ks or cost of equity by using the following equation.

Ks = Krf + (Km - Krf)Bi where Krf is the risk-free rate, or the yield on a long-term
US Treasury Bond
Km is current expected rate of return on the market
Bi is the stock's beta coefficient

Ks = 7% + (13% - 7%)0.73
Ks = 11.38%

The equation can be summarized as follows: -

WACC = WdKd(1 - T) + WcKs where Wd is the weight of debt
Kd is the cost of debt
T is the tax rate
Wc is the weight of equity
Ks is the cost of equity

We need to find the weight of Kd and Ks.

Weight of Kd = $200/($200 + $180) = 52.63%
Weight of Ks = 1 - Weight of Kd = 47.37%

WACC = 52.63% x 10%(1 - 34%) + 47.37%x11.38%
WACC = 8.86%

2. What is the appropriate required return for this project?

However, the signmaking division was more risky than some of the other operations because demand for signs fell sharply during business downturns. It was estimated ...

Solution Summary

This solution is comprised of a detailed explanation to answer the request of the assignment of more than 800 words of text.

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