Case

AAA Health, Inc. (NYSE: A3H) is evaluating a new product, a vitamin C/fish oil blended energy drink. As an assistant director of the capital budgeting division of AAA Health, you are responsible for the evaluation of the proposed project. You collected the following information about the project and the cost of capital. You should make an accept/reject recommendation to the director of your division based on your evaluation.

Information about the Proposed Project

• Initial investment and depreciation: The new drink would be produced in an unused building (owned by AAA Health), which is fully depreciated. The new equipment required for the project would cost $500,000, plus an additional $50,000 for shipping and installation. With the new project, inventories would rise by $60,000, and accounts payable would increase by $10,000. All these costs would be incurred at t = 0. The machinery will be depreciated under the Modified Accelerated Cost Recovery System (MACRS) as 3-year property. The depreciation rates are 33% at t = 1, 45% at t = 2, 15% at t = 3, and 7% at t = 4.
• Project life and salvage value: AAA Health expects to run the project for four years. The cash inflows are assumed to begin one year after the project is undertaken, or at t = 1, and to continue to t = 4. At the end of the projects life (t = 4), the equipment is expected to have a salvage value of $50,000.
• Sales and operating costs: Unit sales are expected to total 50,000 bottles per year, and the expected sale price is $10 per bottle. Cash operating expenses for the project (total operating costs excluding depreciation) are expected to amount to 40 percent of sales revenue.
• Tax rate: AAAs marginal tax rate is 30 percent.

Information for the Cost of Capital Estimation

• AAA Health has outstanding bonds with a 6% annual coupon rate, 10 years remaining until maturity, and a face value of $1,000. The bonds make semiannual coupon payments and currently are trading in the market at a price of $864.10.
• A3H can issue preferred stock with an offering price of $25.00 per share, an annual per-share dividend of $2.40. Flotation costs are equal to 4.0% of the gross proceeds.
• Ten-year Treasury bond yield = 5.52%; the market risk premium = 5%; the beta of A3H = 1.6.
• Target weight of capital: 40 percent debt, 10 percent preferred stock, and 50 percent common equity.
• A3H can undertake a new project without issuing new shares of common stock if the required initial investment does not exceed $600,000. If the initial investment is greater than $600,000, the firm should sell new common stock.

Questions Part I. WACC Estimation 1. Estimate the cost of debt before-tax. 2. Estimate the cost of debt after-tax. 3. Estimate the cost of preferred stock. 4. Estimate the cost of common equity. 5. Estimate the WACC.

Part II. Cash Flow Estimation Assume that there is no alternative use for the building that will be used for the project. 6. Estimate the total amount of the initial investment outlays at t = 0. Hint: Shipping and installation cost and net working capital investment should be considered in the initial investment estimation. 7. Calculate annual sales for Year 1 to Year 4. 8. Calculate annual cash operating expenses for Year 1 to Year 4. 9. Calculate annual depreciation amount for Year 1 to Year 4. Hint: The depreciation basis includes the new equipment cost and shipping and installation cost. 10. Estimate annual operating income before taxes for Year 1 to Year 4. 11. Estimate annual operating income after taxes for Year 1 to Year 4. 12. Estimate annual after-tax operating cash flow for Year 1 to Year 4. 13. Calculate the after-tax salvage value of the equipment. 14. Estimate the total terminal year after-tax non-operating cash flow. 15. Estimate the total after-tax cash flow for Year 0 to Year 4

Part III. Capital Budgeting Techniques Assume there is no constraints for the capital budget. 16. Traditional payback period a. What is the traditional (regular) payback period? b. If the firm is using only regular payback method to make its capital budgeting decision and the target cutoff period is 2 years, should this firm undertake this project? Why?

17. Discounted payback period a. What is the discounted payback period for the project? b. If the firm is using only discounted payback method to make its capital budgeting decision and the target cutoff period is 2 years, should this firm undertake this project? Why?

18. NPV a. What is the projects NPV? b. Based on the results of your NPV analysis, should the firm accept the project? Why?

19. IRR a. What is the projects IRR? b. Based on the results of your IRR analysis, should the firm accept the project? Why?

20. MIRR a. What is the projects MIRR? b. Based on the results of your MIRR analysis, should the firm accept the project? Why?

Part IV. Principles of Cash Flow Estimation 21. Suppose you learned that AAA Health could lease its building to another party and earn $20,000 per year. Should that fact be reflected in the analysis? If so, how?

22. Assume that the new drink project would take away profitable sales from A3Hs existing apple juice/fish oil blended energy drink business. Should that fact be reflected in your analysis? If so, how?

23. Suppose you learned that A3H had spent $50,000 to renovate the building last year. Should this cost be reflected in the analysis? Explain why or why not.