Sam McGee, the financial analyst in the service of Labarge Ltd., is investigating the Midnight Sun project that is quite unlike any of its existing projects. It would require an initial investment of $320,000 and the probable increase in current assets would be 15 percent of this initial investment. The anticipated revenues have been estimated at $90,000 a year for three years, followed by revenues of $115,000 for the remaining four years of the project's life. At end of seven years, any remaining equipment would be salvaged for $25,000. Labarge Ltd. has a tax rate of 38 percent, and the appropriate CCA rate for this capital project is 30 percent. Currently, the firm has 44 percent debt and 56 percent equity in its capital structure, based on market values. It plans to maintain this capital structure in the foreseeable future.
The existing shareholders expect a return of 15 percent on their investment, and new debt would require a 9.53 percent yield. The market risk premium is 8 percent, and the risk-free rate is 3 percent. Sam McGee has examined the betas of firms in the Midnight Sun business, with capital structures similar to that of Labarge Ltd., and this has revealed an average beta of 1.5 for these firms.
a. Calculate the two possible discount rates to analyze the Midnight Sun project.
b. Justify the choice of one of the discount rates.
c. Should Labarge Ltd. proceed with the Midnight Sun project? Show your analysis.
d. How would analysis and decision change if the average beta determined from similar businesses was 2.0 and was based on their equity rather than the overall firm?