You are the CFO if a chicken feed production plant. You are in need of a new pro

Question

You are the CFO if a chicken feed production plant. You are in need of a new processing machine that has a purchase price of $245,000. There would be no need for additional net working capital, so the NCS is the entire NINV of the machine. Now, you have the assignment of figuring out how to pay for it. You have spoken to Bill down at the bank and he says that you can borrow as much as $150,000 at a rate of 9.5%. You would issue common stock to finance the rest. If so, the beta on that newly issued stock would be 1.7. The firm has a tax rate of 35%, the current risk free rate is 3%, and the expected return on the market is 10%.

However, borrowing $150K from the bank would stretch your credit and leave you vulnerable to future financial uncertainties. So, you are also considering a scenario where you would finance the project with only $100,000 in bank loan and the remainder with common stock. In this scenario, the loan on the bank debt would only be 7.0% and the beta on the stock would be reduced to 1.4. Everything else would be unchanged.

A) Given this, what is the WACC for each scenario?

B) The machine is expected to last for 20 years and generate $35,000 in NCFs during each of those years. Given this, and using the best of the two scenarios above, what is the NPV of the project?

Explanation / Answer

Scenario 1 Cost of Debt =9.5% Tax rate =35% Post Tax cost of Debt =9.5%*(1-35%)= 6.18% Beta of new stock =1.7 Risk free rate =Rf =3% Expected return on Market =Rm =10% Cost of Equity =Rf+(Rm-Rf)*beta =3%+7%*1.7=14.9% So cost of Eqity = 14.9% Cost of Machine           245,000 Expected bank loan             150,000 Equity Issue             95,000 WACC calculation Type of capital Market value Weight of Value Post Tax cost of Capital Wtd Cost of Capital Expected bank loan             150,000 61.22% 6.18% 3.78% Equity Issue             95,000 38.78% 14.90% 5.78% Total           245,000 9.56% Scenario 2 Cost of Debt =7% Tax rate =35% Post Tax cost of Debt =7%*(1-35%)= 4.55% Beta of new stock =1.4 Risk free rate =Rf =3% Expected return on Market =Rm =10% Cost of Equity =Rf+(Rm-Rf)*beta =3%+7%*1.4=12.8% So cost of Eqity = 12.8% Cost of Machine           245,000 Expected bank loan             100,000 Equity Issue           145,000 WACC calculation Type of capital Market value Weight of Value Post Tax cost of Capital Wtd Cost of Capital Expected bank loan             100,000 40.82% 4.55% 1.86% Equity Issue           145,000 59.18% 12.80% 7.58% Total           245,000 9.43% WACC A Scenario 1 with $150k debt 9.56% Scenario 2 with $100k debt 9.43% B Scenario 1 Scenario 2 Years   Investment NCF Net Cash flow PV factor @9.56% PV of Net cash flows Investment NCF Net Cash flow PV factor @9.43% PV of Net cash flows Year 0         (245,000)    (245,000)                   1     (245,000)         (245,000)        (245,000)                 1      (245,000) Year 1         35,000         35,000          0.913 31,945.97         35,000             35,000         0.914     31,983.92 Year 2         35,000         35,000          0.833 29,158.42         35,000             35,000         0.835     29,227.74 Year 3         35,000         35,000          0.760 26,614.11         35,000             35,000         0.763     26,709.07 Year 4         35,000         35,000          0.694 24,291.81         35,000             35,000         0.697     24,407.45 Year 5         35,000         35,000          0.633 22,172.16         35,000             35,000         0.637     22,304.17 Year 6         35,000         35,000          0.578 20,237.46         35,000             35,000         0.582     20,382.13 Year 7         35,000         35,000          0.528 18,471.57         35,000             35,000         0.532     18,625.73 Year 8         35,000         35,000          0.482 16,859.78         35,000             35,000         0.486     17,020.68 Year 9         35,000         35,000          0.440 15,388.63         35,000             35,000         0.444     15,553.94 Year 10         35,000         35,000          0.401 14,045.84         35,000             35,000         0.406     14,213.60 Year 11         35,000         35,000          0.366 12,820.23         35,000             35,000         0.371     12,988.76 Year 12         35,000         35,000          0.334 11,701.56         35,000             35,000         0.339     11,869.47 Year 13         35,000         35,000          0.305 10,680.50         35,000             35,000         0.310     10,846.63 Year 14         35,000         35,000          0.279      9,748.54         35,000             35,000         0.283       9,911.94 Year 15         35,000         35,000          0.254      8,897.90         35,000             35,000         0.259       9,057.79 Year 16         35,000         35,000          0.232      8,121.49         35,000             35,000         0.236       8,277.24 Year 17         35,000         35,000          0.212      7,412.82         35,000             35,000         0.216       7,563.96 Year 18         35,000         35,000          0.193      6,765.99         35,000             35,000         0.197       6,912.15 Year 19         35,000         35,000          0.176      6,175.61         35,000             35,000         0.180       6,316.50 Year 20         35,000         35,000          0.161      5,636.73         35,000             35,000         0.165       5,772.18 NPV = 62,147.13         0.151     64,945.04 So NPV of the best scenario 2=$64,945.04

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