Question

Carolyn Nesbitt, the CEO of Macrocorp, is considering a project to expand the existing business into...

Carolyn Nesbitt, the CEO of Macrocorp, is considering a project to expand the existing business into a new product line that involves considerable up-front investments in new equipment as well as an initial investment in net operating working capital. Her executives’ cash flow projections are fairly aggressive with $500 M in sales at the end of the first year increasing by 5% annually for the next five years. Cost of goods sold is expected to be $250M in the first year, increasing by 6% annually for the next five years. The initial equipment costs $1,500M and its salvage value in five years is $750 M. Annual depreciation is calculated using the straight-line method (e.g. an equal amount each year based on the salvage value in five years). The initial investment in net operating working capital is $300M, which Carolyn thinks she can redeploy elsewhere in the firm after five years. After five years, it is expected that the technology will be obsolete. Carolyn expects to pay taxes at a corporate rate of 25%. Carolyn is considering whether to take on the project, as well as how to finance it. Her chief financial officer is proposing to borrow $800 M to finance the equipment and investment in net operating working capital. If the firm borrows to finance the project, its leverage ratio (defined as the ratio of total debt to total assets) would be approximately 53%. The current cost of debt for a five-year bond with principal repayment in five years is 6%. Were the firm to finance the project entirely with equity, the expected return to its investors would be 7.5%.

What is the net present value of the project if it is all equity financed? Should Carolyn take on the project under this financing scenario? Explain why.

Homework Answers

Answer #1
Year 0 1 2 3 4 5
Initial Investment 1500
Sales 500 525.00 551.25 578.81 607.75
COGS 250 265.00 280.90 297.75 315.62
Depreciation 300 300 300 300 300
Net working capital 300 300
Salvage value 750
Cash flow before tax -50 -40 -29.65 -18.9415 1,042.13
Tax -12.50 -10.00 -7.41 -4.74 260.53
Cash flow after tax -37.50 -30.00 -22.24 -14.21 781.60
Net cash flow -1800 262.5 270 277.7625 285.7939 1081.6
Expected return 7.50% If entirely financed with equity
NPV -131.19
Since NPV is negetive Carolyn should not undertake this financing scenario
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