The Thomas Co. is analyzing a proposed expansion project. Currently, the company
ID: 2771822 • Letter: T
Question
The Thomas Co. is analyzing a proposed expansion project. Currently, the company owns 15 acres of land, which it purchased for $6 million 5 years ago. The land is currently valued at $7.2 million and is totally debt-free. The company wants to build a new distribution center at a cost of $19 million dollars, which will be depreciated on a straight-line basis over 30 years. An additional $500 thousand is required for developmental design plans and consulting fees. The center will require an increase in current assets of $2 million during the project life of 20 years. Management has estimated that the facility will increase the firm’s earnings before taxes by $2.5 million a year. After 20 years, the company plans to sell the facility, including the land, for an estimated $15 million.
The company has 50,000 shares of common stock outstanding at a market price of $46 a share. This stock just paid an annual dividend of $2.80 a share. The dividend is expected to increase by 4 percent annually. They also have 10,000 shares of 5 percent preferred stock with a market value of $51 a share. The company has a 8 percent, semiannual coupon bond issue outstanding with a total face value of $1.5 million. The bonds are currently priced at 101 percent of face value and mature in 11 years. The tax rate is 35 percent.
Should the Thomas Co. pursue the expansion at this point in time? Why or why not?
Explanation / Answer
Step 1 calculation of weighted average cost of capital
Cost of equity = D(1+g)/P + g
=2.80(1+0.04)/46 +0.04
=10.33%
Cost of debt = 7.86%
After tax cost of debt = cost of debt x( 1-t) = 7.86%x(1-0.35) = 5.11%
Source Amount Cost Weighted cost
Debt 1.5 m x 101% = 1.515 m 5.11% 0.0774165
Equity 50,000x46 = 2.3 m 10.33% 0.23759
3.815 m 0.3150065
WACC= total weighted cost/ total amount
= 0.3150065/3.815
=8.26%
Step 2
Depreciation = 19,000,000/30 = 633,333
We need to compute NPV to find whether the project is beneficial or not.
NPV = PV of cash inflows – initial cash outflow
= 2258333 xPVIFA(8.26%,20) + 19258333 x PVIF(8.26%,20) -28700000
= 2258333 x 9.6311 + 19258333 x 0.2045 -28700000
= -3012024.38
Since the npv is negative, this expansion project should not be undertaken.
Year 0 1 to 19 20 value of land -7200000 cost of centre -19000000 Design and fees -500000 Increase in working cap -2000000 Increamental ebit 2500000 2500000 (-) taxes 35% -875000 -875000 Net income 1625000 1625000 (+) depreciation 633333 633333 Operating cash flow 2258333 2258333 Working capital recovered 2000000 Salvage value 15000000 Total cash flow -28700000 2258333 19258333Related Questions
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