Schwartz Brothers, Inc., is in the process of deciding whether or not to invest

Question

Schwartz Brothers, Inc., is in the process of deciding whether or not to invest in a project of holiday gifts production and sales. Aaron Buffet is in charge of the feasibility study of the project. To better assess the risk of the project, he used the average of 10 other firms in the holiday gift industry (with similar operation scale and risk) as the benchmark. The figures that he has are as follows:                     Project                       Benchmark

Debt-equity ratio                                35%                              30%

Equity beta                                           ?                                1.5

Cost of debt                                        10%                              12%

The expected market return is 15% and the risk-free interest rate is 7%. The corporate tax rate is 40%. The initial investment in the project is $325,000, and it will generate after-tax cash flows of $55,000 forever. Should Schwartz Brothers invest in this project?

Explanation / Answer

For the benchmark:

Cost of Equity: rS benchmark           = Rf + b (RM – Rf)

= 7% + 1.5 ( 15% – 7%)       

= 19%

WACC:

rwacc benchmark= rwacc project    

19% (1/1.3) + 12% (0.3/1.3) (1– 40%) = rS project (1/1.35) + 10% (0.35/1.35) (1– 40%)

rS project = 19.87%

The PV of the a perpetuity (of the project)      = c/i

, where c is cash flow,

  and i is rS project

The PV of the project = $ 55000/19.87%

                                  = $ 276799.20

Answer:

Since the PV of the project (ie. $ 276799.20 is less than the initial investment of $ 325000, Schwartz & Brothers Inc. should not invest in this project.

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