Question
Hello Inc. is considering the introduction of a new product, The Grill Drill, which will be on the market for 5 years. Introduction of the
Hello Inc. is considering the introduction of a new product, The Grill Drill, which will be on the market for 5 years. Introduction of the new product will require equipment costing $350,000 plus an addition $100,000 for delivery and installation. The firm spent $30,000 over the past two years on consulting services to estimate the demand and potential sales of the new product.
The firm is forecasted to sell $200,000 in Grill Drills each year. Costs of the new product are estimated to be 30 percent of sales. The new project will require an initial increase in net working capital of $15,000.
The equipment will be depreciated using the straightline method to zero over the projects life and is expected to be sold for $65,000 at the end of the project. As previously stated, the firm is in the 40 percent tax bracket. Given that the risk of this project is greater than the average project in the firm, Dental adds two percentage points to the firms weighted average cost of capital (WACC). Calculate the projects net present value (NPV) and state whether the firm should introduce the product or not. [Note: Be sure to make clear what discount rate you are using.
Debt:
Number of bonds outstanding = 2,000
Face Value = $1,000 Current Price = $985
Value of Debt = 2,000 * $985 Value of Debt = $1,970,000
Annual Coupon Rate = 5.00% Semiannual Coupon Rate = 2.50% Semiannual Coupon = 2.50% * $1,000 Semiannual Coupon = $25
Time to Maturity = 8 years Semiannual Period = 16
Let Semiannual YTM be i%
$985 = $25 * PVIFA(i%, 16) + $1,000 * PVIF(i%, 16)
Using financial calculator: N = 16 PV = -985 PMT = 25 FV = 1000
I = 2.616%
Semiannual YTM = 2.616% Annual YTM = 2 * 2.616% Annual YTM = 5.23%
Before-tax Cost of Debt = 5.23% After-tax Cost of Debt = 5.23% * (1 - 0.40) After-tax Cost of Debt = 3.138%
Equity:
Number of shares outstanding = 300,000 Current Price = $18
Value of Common Stock = 300,000 * $18 Value of Common Stock = $5,400,000
Cost of Common Equity = Risk-free Rate + Beta * Market Risk Premium Cost of Common Equity = 4% + 1.3 * 6% Cost of Common Equity = 11.80%
Value of Firm = Value of Debt + Value of Common Stock Value of Firm = $1,970,000 + $5,400,000 Value of Firm = $7,370,000
Weight of Debt = $1,970,000/$7,370,000 Weight of Debt = 0.2673
Weight of Common Stock = $5,400,000/$7,370,000 Weight of Common Stock = 0.7327
WACC = Weight of Debt*After-tax Cost of Debt + Weight of Common Stock*Cost of Common Stock WACC = 0.2673 * 3.138% + 0.7327 * 11.80% WACC = 9.48%
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