Colurost, Inc. manufactures parts for the classic auto restoration industry. The company is evaluating a proposal by its R&D department to develop one-of-a-kind, customize parts for resto-mod professionals and the hobbyist in their desire for that special, unique new old car/truck. This approach will require the expertise of design artists and engineers working with the restorer and the need for custom programs, computer aided design, CNC milling equipment and metal 3D printing equipment Market studies indicate that the restoration market is continuing to grow and it broadening to include the newer classic vehicles of the 80s and 90s. The industry includes both professional restoration shops and many talented hobbyists. The anticipated demand is incorporated in the forecasts below.

Sales Forecast: The estimates of sales revenues for this project are: o Year 1: 950,000 o Year 2: 2,185,000 o Year 3: 3,277,500 o Sales are expected to continue to grow in years 4, and 5 by 10% per year. o Sales in years 6 and 7 will be flat (equal to year 5). o Sales are then expected to decline by 10% per year in years 8 and 9. Production cost forecasts are: o Fixed costs: $377,000 per year (a large portion of this cost is labor for the designer and engineer). o Annual variable costs: 49% of revenue. The company will have to purchase new equipment, mentioned above, to produce the new product. The equipment, including shipping and installation is expected to cost (t=0) $ 7,575,000. The equipment falls into the IRS 7-year class life using the MACRS depreciation method with the year convention. You may use the IRS - MACRS depreciation table below. If the company goes ahead with the proposed product, it will have an effect on the companys net operating working capital. At the outset, t = 0, inventory will increase by $365,000. Accounts payable will increase by $255,000 and accounts receivable will increase by $110,000. The net operating working capital will be liquidated after the project is completed.

The program (project) is planned to continue for 9 years. At the end of the project the equipment will be salvaged (sold). The forecasts predict that the equipment can be sold then for $195,000. The company has a marginal (federal + state) tax rate (T) of 34%.

MACRS (half-year convention) Depreciation (% of depreciable basis) Class - life Year of Operation 3-Year 5-Year 7-Year 10- Year 1 33.33% 20.00% 14.29% 10.00% 2 44.45% 32.00% 24.49% 18.00% 3 14.81% 19.20% 17.49% 14.40% 4 7.41% 11.52% 12.49% 11.52% 5 11.52% 8.93% 9.22% 6 5.76% 8.92% 7.37% 7 8.93% 6.55% 8 4.46% 6.55% 9 6.56% 10 6.55% 11 3.28%

Your analysts compiled current market information: o Market risk premium (rm rrf): 4.00% o Risk-free rate (rrf): 1.03% The companys beta (at its current capital structure) is: 1.55 Current Capital Structure Colurost has the following levels of debt and common equity (market values): o Debt: $2,595,000 o Equity: $6,056,000 o Total Capital: $8,651,000 Colurost, Inc. uses the firms WACC for average risk projects, it adds 2% for high risk projects. For low risk projects it uses the WACC less 2%.

Management utilizes risk adjusted hurdle rates for evaluating capital budgeting projects. All potential projects are classified using a five level classification system: Risk Level Class Hurdle Rate A Low risk WACC 2 B Below average risk WACC 1 C Normal risk Equal to the WACC D Above average risk WACC + 1 E High risk WACC + 2 Colurost, Inc. considers this to be a high-risk project. After discussions with an investment banker about issuing additional debt, your analyst found that the cost of debt (before tax) depends on the amount of debt in the capital structure. Cost of debt estimates for various levels of debt financing (D/E) were obtained and the firms analysts have partially prepared information for the companys cost of capital at various levels of debt and equity:

Capital Structure Worksheet D/E D/A (Wd) rd rd(1-T) b E/A (Wce) re WACC 0 0.000 0.00% 0.00% 1.21 1.000 5.86% 5.863% 0.43 0.300 3.25% 2.15% 1.55 0.700 7.23% 0.400 3.875% 2.56% 7.99% 5.817% 1.00 4.75% 3.14% 2.01 6.094%

Where: o rd = before tax cost of debt, o rd(1-T) = after tax cost of debt, o b = beta, o rs = cost of common equity, o Wd = Weight of debt, o Wce = Weight of common equity,

Given all of the information provided in this case: (Show your work, calculations, and explain your answers well) Cost of Capital, Capital Structure, Hurdle Rate: What is the firms current Weighted Average Cost of Capital (WACC) at its current capital structure. Capital Structure theory addresses finding a firms optimal capital structure. How do you determine the optimal capital structure? What is the SPIs optimal capital structure? (Complete the Cost of Capital & Capital Structure worksheet) Define Hurdle rate. What is a Risk-adjusted Hurdle Rate? Based on SPIs current capital structure, what is the appropriate Hurdle Rate for the project? Capital Budgeting: Please complete the capital budgeting analysis for this project. You should develop the incremental cash flows: o Initial investment cash flow at t=0, o Operating cash flows through the life of the project, o Terminal cash flows You should evaluate the project using: o Net Present Value, o Internal Rate of Return, o Modified Internal Rate of Return Present your decision whether the project should be accepted or rejected, and justify. Finally, Beatrice, a financial analyst at Colurost, has worked time during the last year developing the project idea and proposal. She did not include her time in the project analysis you completed, however her supervisor believes that including the cost of Beatrices time in the cash flow estimates as an expense is appropriate. This amounts to $32,500 (one-half year salary + benefits). They have asked you how should this be handled (discuss)? That is, should it be included in the analysis? Why/Why not?