PROMPT: Labs Inc. has an equity beta of 2 under capital structure (D/E) = 1. The

Question

PROMPT:

Labs Inc. has an equity beta of 2 under capital structure (D/E) = 1. The current cost of debt for the firm is 7.5%. The projected firm's unlevered free cash flows in 2018 and 2019 are $111 million and 120 million, respectively. After 2019 cash flows are expected to increase 2% every year. Labs Inc. is considering investing in a new business in a different industry. The new project has a publicly traded competitor that is fully equity financed. Its equity beta is 3. The management of Labs Inc. is planning to use a D/V ratio of 0.4 for the new project. The borrowing rate is expected to be 6% for this project. The initial cost of the project is $150 million today. The new project is expected to produce sales revenue of $40 million in 2018 and this is expected to grow 3% every year. However, to sustain this sales level, they will have to make an investment of $3 million in PP&E in year 1 and this amount is expected to grow every year by 2%. Assume that (i) depreciation tax shields during all future years will equal to the investment in PP&E and (ii) there is no investment in NWC. According to forecasts, the cost of goods sold (excluding depreciation but including selling and general expenses) will be 40% of sales levels in each year.

Tax rate 40%

Yield on short term US T-bills 1%

Yield on long term US government bonds 4.0%

Risk premium (Rm-T-bills) 8.0%

Risk premium (Rm- gov. bonds) 6.75%

QUESTIONS:

1. Prepare a financial statement to determine the unlevered free cash flows of the new project.

2. What would be the recommendation regarding the new business, if one uses Lab Inc.’s WACC to discount the cash flows of the new project? Is there anything conceptually wrong with this approach?

3. What is your analysis and make recommendation regarding the new business?

Explanation / Answer

Answer:

a) Unlevered financial statement of the New business:

Freec cashflow of the new business:

b)WACC of old business:

Notes to calculate wacc=kd *(I- tax rate)* D/V+Ke*E/V

Kd=cost of debt*(1- tax rate)=7.50%*(1-0.40)=5%

D/E= 1 so total debt and equity are equal in the total capital structure

Cost of equity= Risk free rate+equity beta*( Market return - Risk free rate)

since in this market return of bonds are given we r taking long-term bonds return as RM proxy

=4%+2*(6.75%-4%)

=14%

so wacc=0.50*5%+0.50*10%=7%

WACC of new business:

DCFF at rate of old business WACC

from above table, we can identify that with old WACC the value of cash flows increase which gives wrong picture of project cash flows. so we can not discount the future cash flows at the old business WACC. It's conceptually wrong as well since the debt-equity structure of both the company are different which can influence the WACC rate also.

c) we can make recommendation of new business with the help of calculating NPV of the new business:

since NPV of the project or new business is negative it's not worthwhile to make an investment in the new project.

(ends)

financial statement of unlevered cashflow in Million 2018 2019 sales 40 41.2 Minus cogs @ 40% of sales 16 16.48 gross profit 24 24.72 Minus dep(dep is equal to investment in PPE) 3 3.06 EBIT 21 21.66 Minus Interest cost 0 0 PBIT 21 21.66 Tax Rate @ 40% 8.4 8.7 PAT 12.6 13.0

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