Question
Answer Handwritten or Excel. You are the manager of the peanut division at Peanuts & Grains, Inc. You are considering a new project to make
Answer Handwritten or Excel. You are the manager of the peanut division at Peanuts & Grains, Inc. You are considering a new project to make peanut butter. The project will require a $25M up-front investment in new equipment, and is expected to last for four years. However, the equipment will be depreciated straight-line to zero based on a 10-year useful life. You expect to sell the equipment for a price equal to its remaining book value at the end of the four years, when the project is finished.
The project is expected to produce $15M in revenue the first year, which will increase by $5M per year over the following three years. Costs (excluding depreciation) will equal 60% of revenues. The project will also require a $3M up-front (time zero) investment in working capital. The working capital balance at the end of years 1 through 3 will equal 20% of the next years revenue. All working capital will be recovered in the fourth year of the project. The corporate tax rate is 21%.
To help you calculate a discount rate, you have gathered information about a comparable peanut butter manufacturer, Peanuts R Us. It has a D/E ratio of 0.4 and a debt beta of 0.5. You looked up its equity beta on Yahoo Finance and found an estimate of 0.95. The current risk-free rate is 1.5%, and your estimate of the market risk premium is 6%.
a. What are the projects forecasted incremental free cash flows?
b. What is the appropriate discount rate for the project if you expect to operate it with the same D/E ratio as Peanuts R Us, and its debt is expected to have a beta of 0.5 as well? What is the projects NPV with this discount rate?
c. What would be the appropriate discount rate for the project if you instead planned to operate it with a D/E ratio of 1.5, and, given the higher leverage ratio, the projects debt would be required to yield 5%? What is the projects NPV with this discount rate?
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