FIN $332$

Integrative Case Study

You have been asked to evaluate proposal to expand one of X Co$$s existing plants and make recommendations. X Co$.$ produces batteries and sells them by the case.

Proposal

The current plant has a capacity of $260,000$ cases per year. The first proposal is for major expansion that would increase the plant$$s current capacity to $500,000$ cases per year. After talking with the firm$$s design engineers, sales managers and plant operators, you have prepared the following estimates:

$$ Installing the new equipment and redesigning the plant to accommodate the higher capacity will require shutting down the plant for $4$ months. During that time, the plant$$s production will cease. After the expansion is finished, the plant will operate at its new capacity.

$$ Marketing and selling the additional volume will lead to $$1\mathrm{.}5$ million per year in additional sales, marketing, and administrative costs. The costs will begin in the first year $($even while the plant is under construction and shut down$).$

$$ Expanding the plant will require the purchase of $$3\mathrm{.}0$ million in new equipment and entail up$-$front design and engineering expenses of $$3\mathrm{.}5$ million. These costs will be paid when the expansion begins.

Other Relevant Information

X Co believes that with or without expansion, the technology used at the plant will be obsolete after $6$ years and will have no salvage value, and the plant will need to be completely overhauled at the time.

You have been provided with the following additional information:

$$ With or without expansion, X Co$.$ will be able to sell all it can produce at an average wholesale price of $$75$ per case. This price is not expected to change over the next $6$ years.

$$ X Co$.$ has a gross profit margin on $60\%$ on these batteries

$$ X Co$$s average net working capital at the end of each year will equal $10\%$ of annual revenue except for the last year of the operation.

$$ X Co$.$ pays a $35\%$ corporate tax rate.

$$ While all design and engineering costs are immediately deductible $($also for tax purposes$)$ as operating expenses, all capital expenditures will be straight$-$line depreciated for tax purposes over the subsequent $6$ years.

Management believes the risk of the expansion is similar to the risk of X Co$$s existing projects, and because X Co is all equity financed, the risk of the expansion is also similar to the risk of X Co$$s$.$ stock. You have the following information about the stock:

$$ X Co$.$ has no debt and has $2$ million shares outstanding. The firm$$s share price is $$70$ per share. The total book value of the shares is $$10,000,000.$

$$ Analysts are expecting X Co to pay a $$3$ dividend at the end of this year, and to raise its dividend at an average rate of $8\%$ per year in the future.

Based on this information, you have been tasked with preparing expansion recommendations for X Co$.$

Part I

In order to manage this task, you need to:

$$ Determine the annual incremental free cash flow associated with each expansion proposal relative to the status quo $($i$.$e$.,$ no expansion$).$

$$ Compute the payback period for each expansion proposal and conclude which project should be chosen.

$$ Calculate the equity cost of capital and then the Net Present Value of each alternative and conclude as to which project should be chosen.

Part II

Instead of being solely financed with equity, X Co$.$ also has an issuance of bonds outstanding. The bonds are being sold at par for $$1,000$ with an annual coupon rate of $4\%($paid semi$-$annually$).$ The bonds price in the market is $$1,000.$ The bonds have a value of $$50,000,000.$

Calculate the weighted average cost of capital given the above information on equity and on debt. Recalculate the net present value and conclude as to which project should be chosen $($if any$).$