This is what I\'m doing a case assignment on. I have created cash flow charts an

Question

This is what I'm doing a case assignment on. I have created cash flow charts and I have an idea about what Im going to say for the 5 essay questions at the end. However I have been using a Weighted Average Cost of Capital of 19.28% and I don't believe that's correct. My main goal in this posting is to confirm that my WACC is correct or to get the correct WAAC. Also what implications does a lower WACC have on the essay questions (if any). I know that a lower WAAC is better for the borrower, and a higher one is of course worse. I was getting some negative net present value results, this would cause us to steer Gus away from the project. I redid the formulas with a lower WACC of 5% and I got positive NPVs (which is of course better because it would cause us to want to invest in the project), however I cannot simply change my WACC to 5%. I need to know why. I tried doing the formula myself for WACC but I messed it up....

Thank you so much for your help!

Worden Oil Company

Gus Worden is the chief operating officer of the Worden Oil Company in Litchfield, Connecticut. The company delivers petroleum products to gasoline stations. Gus has an opportunity to negotiate a new six-year contract hauling for a chain of independent gasoline stations. Since Gus fully employs his tractor-trailer units, the contract would require the purchase of a new “rig” at a cost of $500,000.

The New Rig. To be profitable a rig should log at least 100,000 miles per year. To prolong the rig’s life, Gus would overhaul major systems after four years. This could cost as much as $60,000, but would ensure that the rig would last well beyond six years. The cost of the overhaul is a normal operating expense for tax purposes. After six years Gus would sell the rig for an expected salvage value of $50,000(conservative estimate).

The Accelerated Cost Recovery System classifies the rig as a “five year asset” for depreciation purposes.

Projected Revenues. Gus is uncertain about the revenue that this contract will generate. Since revenue varies directly with the number of gallons delivered, Gus will earn more revenue if the independent gasoline stations experience high sales volume. Hence, if petroleum prices are low, Gus’s volume and revenue should be high. Of course, the price of petroleum is determined by world markets.

Gus’s best estimate is that the rig will deliver 100,000 gallons per day (on average). However, sales could be as low as 88,000 gallon per day or as high as 112,000 gallons. Gus believes that the probability of selling 88,000 gallons or less is no greater than 20%. Similarly, the probability of selling 112,000 gallons or more is no greater than 20%.

Total delivery revenues will depend on how many days per week Gus keeps the rig in service. If the rig runs five days per week, Gus expects to earn delivery revenues of $.025 per gallon. If the rig runs six days per week, Gus expects to earn average delivery revenues of only $.023 per gallon. Price concessions are essential to contract marginal business. Since the rig requires regular preventative maintenance, a seven-day week is not feasible.

Operating Expenses. Most operating expenses are closely related to delivery revenues. Wages and benefits run approximately 35% of revenues. Diesel fuel is 25% of revenues. Regular maintenance expenses average $25,000 per year plus between 7% and 9% of revenues. Insurance, registration and road taxes are fixed at $20,000 per year. Incremental administrative costs are $5000 per year. Finally, Gus will garage the new rig in a bay which the company owns and currently rents out for $20,000 per year.

The firm’s marginal tax rate is 34 percent.

The Cost of Capital. Gus plans to use a 9 percent discount rate to evaluate this investment opportunity. This is the interest rate which he pays on new bank debt. Although Gus has financed other recent investments with retained earnings, he plans to rely entirely on bank debt to finance the new rig.

Worden Oil is 70 percent equity financed and 30 percent debt financed. The stock is owned strictly by family members, who claim that they require a 25 percent return on their investment. However, Gus estimates that historically the company has rarely earned more than a 16 percent return on equity (ROE), and stockholders seem quite satisfied.

Gus’s Decision. Gus has requested your help. Build a spread sheet model projecting the net cash flow that this project will generated over time. Conduct a scenario analysis examining the attractiveness of the project under pessimistic, most likely and optimistic scenarios. Estimate several profitability metrics for each scenario.

Help Gus answer five pressing questions:

1. What discount rate should Gus use to evaluate this project?

2. Should Gus accept the six-year contract?

3. If so, should he operate the rig five days per week or six days?

4. How risky is this project?

5. If Gus chooses to invest, what managerial actions could increase the likelihood that this project will be profitable?

Explanation / Answer

Question 1 Gus should 9% as it is the market rate of return. Question 2. Expected Delivery = 88,000 x 0.2 + 100,000 x 0.6 + 112,000 x 0.20 =100,000 gallon 5days week 6days week Annual Sales Revenue 650000 717600 Expenses: Wages and benefits @35% 227500 251160 Fuel expenses @25% 162500 179400 Maintenance (25000 + 9%) 83500 89584 Insurance and taxes 5000 5000 Rent expenses 20000 20000 Total Expenses 498500 545144 Income before depreciation 151500 172456 Depreciation (500000-500000)/6 75000 75000 Net Income 76500 97456 Less: Tax @34% 26010 33135.04 Income After Tax 50490 64320.96 Add: Depreciation 75000 75000 Cash from operation 125490 139321 Cashflows pv factor Present value Year 5days week 6days week at 12.98% 5days week 6days week 0 -500000 -500000 1 -500000 -500000 1 125490 139321 0.9174312 115128.4 127817.4 2 125490 139321 0.84168 105622.4 117263.7 3 125490 139321 0.7721835 96901.3 107581.3 4 65490 79321 0.7084252 46394.77 56192.97 5 65490 79321 0.6499314 42564.01 51553.18 6 115490 129321 0.5962673 68862.91 77109.86 Total -24526.1 37518.42 in 6 th year rig will be sold at 50,000 and so cash will be added in the cashflows in 4th year, company has to pay 60,000 for maintenance. That has been deducted from cash inflows Answer: Gus can accept the contract Question 3. Gus should operate 6 days a week Question 4: This project is risky. Since company is going to finance the rig through bank finance, a small change in the delivery revenue will result in loss. (Expected Sales (Variance)^2 Probability Variance)^2 80000 400000000 0.2 80000000 100000 0 0.6 0 112000 144000000 0.2 28800000 Total 108800000 standard Deviation = square root(108800000) =10430 Question 5. Managers can take action to increase the delivery revenue by transporting as much as possible per day.

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