Question

Company: BubblePop Project: APPKiller You’re the CFO of the tech company, BubblePop. Your CMO (Chief Marketing Officer) is proposing a new product called APPKiller that will be sold online for $10 per unit. The CMO expects sales of 100,000, 110,000, 120,000, 90,000 and 70,000 units over the products 5 year life. COGS is 20% of sales and operating expenses are estimated at $350,000 per year. The company’s tax rate is 30%.

The initial investment in the project is as follows.

 $1,000,000 for fixed equipment machinery

 $200,000 in initial raw materials

The machinery is depreciated over 8 years straight-line ($125,000 per year).

At the end of 5 years, the product is expected to become obsolete. The machinery will be sold off for $600,000 at that time. Raw materials will be sold off netting the company the $200,000 back that they had originally invested.

FYI, the company has already spent $75k on an overpriced consultant last year analyzing this deal. (I heard he was a college professor in RI).

Oh, and about their WACC……

 The company’s stock is trading for $20 per share. There are 50,000 shares outstanding. Company beta is 2.0. The market risk premium is 6% and the risk free rate of return is 3%.

 Corporate debt matures in 2020 and is trading at 90% on 800 bonds with a par value of $1,000. The coupon rate is 10%. The bonds pay coupons semi-annually (2x per year).

 The company has a small amount of Preferred stock. 2,000 shares trading at $90. Par value is $100 and annual income on the Preferred stock is 9.5%.

Using NPV, should the company invest in the APPKiller project?

Answer 1

A. Amount paid to the consultant is sunk cost and will not affect decision making. The same has to be ignored in our calculations.

B. The time period of corporate debt is unclear from the question, hence the same is taken to be 10 years.

C. Notes with regard to the calculation are as follows:-

• Interest on loan = 10% of $800,000 every year = $80,000
• For calculating Free cash flow for firm, we take Net income+ depreciation +interest (1-t) - capex - net working capital. Hence, we calculated the present value of (NET INCOME + DEPRECIATION + INTEREST(1-T) including terminal value) and we subtracted initial investment and net working capital change.

D.

	year 0			Years	1	2	3	4	5			year 5
Initial investment	(1,000,000)			Production							Terminal value - machine	600,000
NWC change	(200,000)			Sales	100,000	110,000	120,000	90,000	70,000		tax saving on capital loss	120,000
Initial investment	(1,200,000)			Revenue per unit	10	10	10	10	10		Terminal value - NWC	200,000
				Revenue	1,000,000	1,100,000	1,200,000	900,000	700,000			920,000
				-COGS	(200,000)	(220,000)	(240,000)	(180,000)	(140,000)
				- operating expenses	(350,000)	(350,000)	(350,000)	(350,000)	(350,000)
				EBITDA	450,000	530,000	610,000	370,000	210,000
				-dep	(125,000)	(125,000)	(125,000)	(125,000)	(125,000)
				EBIT	325,000	405,000	485,000	245,000	85,000
				-intt	(80,000)	(80,000)	(80,000)	(80,000)	(80,000)
				PBT	245,000	325,000	405,000	165,000	5,000
				-tax@30%	(73,500)	(97,500)	(121,500)	(49,500)	(1,500)
				PAT	171,500	227,500	283,500	115,500	3,500
				+dep	125,000	125,000	125,000	125,000	125,000
				+interest(1-t)	56,000	56,000	56,000	56,000	56,000
				FCFE	352,500	408,500	464,500	296,500	184,500
				+Add terminal value					920,000
				Discounted to T=0 @11.29%	316,745	329,833	337,008	193,299	647,027
				Total Present value	1,823,913
				Net Present Value	623,913

E. WACC calculation is as follows:-

Price	20
no. of shares	50,000
CAPM (Re) = Rf+(Rm-rf)*Beta
Re (cost of equity)	15%
Par value
	48,000
	760,000
	6.32%
YTM(Cost of debt)	6.32%
Cost of preferred debt	10.56%
total market value of all debt and equity	1,900,000
		market value	weights
Equity	15.00%	1,000,000	0.53
debt	6.32%	720,000	0.38
preference	10.56%	180,000	0.09
		1,900,000	1
WACC	11.29%