Question
Dr. Chris Piker is evaluating the merits of a potential investment in a drone manufacturing company. He already owns the land for the facility, but
Dr. Chris Piker is evaluating the merits of a potential investment in a drone manufacturing company. He already owns the land for the facility, but he would need to purchase and install the assembly machinery for $230,000. The machine falls into the MACRS 5-year class (refer to the table in Chapter 11 Appendix), and it will cost $15,000 to modify it for Dr. Piker's particular needs. A consultant, who charged Dr. Piker $10,000 for his services, already completed the process of restructuring the facility for the required zoning and industry standards. The facility requires additional net working capital of $5,000. Drone sales are expected to yield before-tax revenues of $450,000 per year with labor costs of $200,000 per year and fixed costs of $180,000 per year. Dr. Piker expects the machine to be used for 5 years and then sold for $60,000. Dr. Piker has asked you to evaluate his proposed project, and he has provided you with the following information about the investment: Dr. Piker has a target capital structure of 30% debt, 10% preferred stock, and 60% common equity. He plans to issue bonds with a 6.5% coupon, paid semiannually, a maturity of 10 years, and sell them for $1,000. He also believes that he could sell, at par, $50 preferred stock that pays an 8.5% annual dividend, but flotation costs of 6% would be incurred. He estimates the beta of this project to be 1.5, the risk-free rate is 4%, and the expected return on the market portfolio is 12%. Dr. Piker plans to issue shares of common stock for $35 apiece, with an initial dividend of $3.15 that is expected to show constant growth of 5%. He uses a risk premium of 5.5% when using the bond-yield-plus-risk-premium method to find the cost of equity. His estimated marginal tax rate is 38%. In addition to finding the firm's average-risk cost of capital, Dr. Piker has also asked you to calculate a risk-adjusted cost of capital. He believes that the project's cash flows for years 1 through 5 (including any Terminal CFs) will increase by 10% in a particularly good market, and the cash flows will decrease by 10% in a particularly bad market. He estimates that there is a 15% probability of a good market occurring, a 25% probability of a bad market occurring, and a 60% probability of an "average" market occurring. To complete this task of calculating a risk-adjusted cost of capital, you will need to find the expected NPV, its standard deviation, and its coefficient of variation (CV). Dr. Piker informs you that his average project has a CV in the range of 1.0 to 2.0. If the CV of a project being evaluated is greater than 2.0, 2 percentage points are added to the cost of capital for the evaluation. Similarly, if the CV is less than 1.0, 1 percentage point is deducted from the cost of capital for the evaluation. In the end, Dr. Chris Piker wants to know whether to accept or reject the project. He expects you to make your conclusion using 3 techniques: discounted payback method, NPV analysis, and IRR analysis.
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