Calculation & Recommendation
I would recommend that Fine Food Catering undertake the expansion. The net present value of the project is -$86,477. As a rule of thumb, firms should never undertake projects that have a negative net present value. The net present value derives from the following calculations.
The initial investment is $260,000, which is in today’s dollars. Future cash flows are discounted by the hurdle rate, 14%, which represents the amount needed to account for the risk of the project. These future cash flows were calculated on the basis of several assumptions. Operating 250 days per year, with 75% of the 200 turned-away customers estimated to come into the expanded facility, this gives us 37,500 extra customers per year. The average ticket is $5.40, giving us a contribution of $3.24. Multiplied by the expected number of new customers, this gives us $121,500 in expected annual contribution flows attributable to the expansion.
There are several expenses incurred as a result of the expansion. The new hires we will need to make cost $62,000 per year. Additional cleaning expenses, based on 250 days per year, will be $11,250. Additional inventory requirements will cost $20,250 per year. This gives us an EBITDA of $28,000. The depreciation expense, at a CCA of 15%, gives us a tax shelter for 6 2/3 years. This tax shelter means that we do not pay tax on the additional income until the seventh year, with the depreciation tax shelter having disappeared completely by year 8. The salvage value contributes profit in year 20.
The impact of the discount, rate, however, negates much of the impact of the salvage value. By the time the depreciation tax shelter has lapsed in year 8, the present value of the cash flows is less than $8,000. Thus, the cash flows over the 20-year period do not make a large enough contribution to cover the initial $260,000 outlay.
b. If the discount rate used was 12.5% instead of 14%, this would not make a difference to the recommendation. I would still recommend that FFC not undertake the expansion. The NPV of the project would be at 12.5% a value of -$71,105. Intuitively, we know that the time value of money means that a small change in the discount rate is not going to have a significant impact beyond the first few years. In those first few years, cash flows are not large, even with the depreciation tax shelter. The company would need to make more money in the short run with respect to this project, in order to justify it.
Q2. a. The cost of capital can be calculated by calculating the cost of the different constituents of capital. To calculate the cost of debt, we must estimate what the new bonds will cost. Using a bond calculator, we know that their current bonds are yielding 6.76%. Once adjusted for annual interest to accommodate the bond calculator, the Magna bonds are trading at a yield of 8.60%. This means the yield needed for our new bonds is 8.90% over 25 years. Given the issue price of 102.00, this will require a coupon of 10.3%. Add to this the 2.2% cost. This brokerage fee is tax-deductible, so the after tax cost of the brokerage fee is 1.76%. Thus, the total cost of debt for Byfield is 10.3+1.76 = 12.06%.
The current yield on Byfield preferred stock is 8.95%. Add to this the cost of issuing the stock, which is 2.7%, or 2.16% after tax, and the cost of preferred equity is 11.11%. We can use the dividend discount model to calculate the cost of equity, which will be 19.1%. Add to this the after-tax brokerage costs 3.864% to get a cost of equity of 22.964%. From there, the weighted average cost of capital is going to be (.38)(.1206)+(.14)(11.11)+(.48)(.2296) = 17.15%.
Based on this average cost of capital, the only project that Byfield should undertake will be the thermal transfer colour printer. This project has an expected return of 18.8%, which is greater than the cost of capital (hurdle rate). The other two projects will return less than they cost.
b. In the phrase “cost of capital,” the debt, preferred stock and equity all have a cost. To raise money via each of these requires making payment to the party providing the money. In the case of equity, this is future cash flows and those are not guaranteed, which is why the cost of equity is highest (it is riskier). But Byfield must provide a return to the provider of the capital that is commensurate with the company’s risk.
Knowing the cost of capital is critical for a company. Because raising capital has costs – returns given and brokerage fees – associated with it, any investment the firm makes must exceed the cost of capital. Any project undertaken that does not yield in excess of the cost of capital is, in effect, costing the company money. The thermal printer is a viable project because it will earn Byfield more than it costs (assuming Byfield leaves its capital structure intact). The other projects will also earn Byfield money, but they will not earn Byfield enough money to pay for the cost of the money Byfield spent to undertake the project. Thus, the cost of capital becomes the basis for all capital decisions, because it represents the market’s view of the firm’s inherent risk. Cost of capital is also a good starting point for the evaluation of projects that bear more risk or less than the firm’s typical operations.
The hurdle rate for such projects can be adjusted using the normal cost of capital as a starting point.
Bond Calculator: http://www.smartmoney.com/investing/bonds/bond-calculator-7917
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