In January 2020, Mr. Palp, chairman and chief executive officer of Eden's Delight (ED) faced an important decision about expanding his food company into a new line of frozen food products. The proposed $6 million project, Mr. Palp thought, would lead to a paradigm shift for consumers concerned about food safety during the COVID-19 pandemic. Company Background Founded in 1981 as a farming business in Conecuh County, Alabama, Mr. Palp Sr. entered the food business mostly by chance in 1992 when a food company to whom he had sold produce went into bankruptcy and he received the whole food processing plant as part of the settlement. From that small beginning, ED evolved into one of the largest food processing companies in the United States in addition to its farming business. By 2020, the company had over 25 different plants across the country. Processed Food Industry ED had been phenomenally successful when judged in terms of growth and profitability (see Exhibit 1). However, the business was not without its risks. There were two principal sources of risk: supply and demand, both of which were highly uncertain. With regard to supply, profitability was affected by events beyond the control of management. Climate change, for example, was making harvest quality and quantity unpredictable, leading to a volatile cost base. With regard to demand, new trends in healthy lifestyle habits of consumers and their fickle preferences made seasonal planting decisions difficult. Also, when there was a new, trendy ingredient from an exotic land, consumers were quick to switch. Mr. Palp still remembered missing out on the quinoa trend. He was luckier when the avocado trend was in full swing. All in all, the processed food business had its risks. Frozen Food Industry It was difficult to obtain accurate data on sales and profitability of the various competitors because most of them tended to be local, privately-owned subcontractors. However, there were six publicly traded companies: Agro Blast, Flash Buds, Green Thumbs, Healthy Grains, Macro Tastes, and Yummy Veggies. Only Agro Blast and Flash Buds concentrated in the frozen food industry, while the other four had additional business segments such as canned and packaged foods. Summary data for these six companies are shown in Exhibit 2. Staff had determined that it would cost $6 million to install the machinery necessary to make frozen food products. If the engineering work started in the first quarter of 2020, the project could be finished by the beginning of 2021. Staff had also projected that it would be necessary to invest heavily in advertising and marketing in the early years. The brand image of a new product was an essential contributor to success. Pro forma data for the project are shown in Exhibit 3, which assumes that the annual inflation rate will be 3%. Current operating liabilities of the project were expected to be 10% of total sales. The tax rate on income from the project was expected to be 38% (the combined U.S. federal and Alabama state tax rate). Any losses from the project in the early years would be used to offset the company's profits. Some data on capital market conditions are provided below. Mr. Palp thought that the project looked attractive, but was concerned that accepting it might reduce the company's high rate of return on invested capital. Please answer the following questions. There are a total of 100 points allocated as indicated below. Be explicit about the assumptions you are making and show your work. Good luck. (1) (40 points) (a) Based on the Capital Asset Pricing Model, what is the appropriate weighted average cost of capital for ED's investment in the new project to make frozen food products? (b) Do a sensitivity analysis for WACC for the following cases: Debt ratio of 0% Debt ratio of 10% Debt ratio of 50% From now on you can assume that the weighted average cost of capital is 13%. a) (30 points) (a) What are the forecasted free cash flows for the project through 2026? (b) What is the present value of these cash flows? o (20 points) On the assumption that the project lasts forever with the appropriate maintenance, what is the terminal value of the project if there is no real growth beyond 2026? What is the total value of the project? (4) (10 points) Conduct an alternate valuation of the project by using the market-to-book ratio of comparable firms. Selected Capital Markets Data in December 2019 Interest Rate-Long Term AAA 52% Interest Rate Long Term AA 55% Interest Rate Long Term A 53% Interest Rate-Long Term BBB 61% Short Term T-Bills 4.3% Long Term Government Bonds MRP sand 6.9% Exhibit 1 ED, Inc.-Income Statement and Balance Sheet (5000) 2014 2015 2016 2017 2018 2019 Income Statement Sales Cost of goods sold SG&A expense 20218 22437 32.090 34.192 11.360 14,982 18,173 19,614 1.007 1424 1.332 2.571 44,09871,436 31.01338,399 3,176 3,944 Operating income Interest expense 7851 548 667 6031 12,586 749 12.00 9,910 29,092 744 975 756 Pretax income 7304 5365 11,836 11.264 8,935 28.336 Taxes 2350 1878 4,143 3,942 3,127 9.918 Net income 4.747 3,487 7,94 7.322 5,308 18,413 Dividends 1.526 1,79 2.087 5.945 Balance Sheet Cash 526 269 675 1.025 1.323 1.364 Accounts receivable Inventories 1.233 1,750 1.989 4.533 7446 6.114 2065 2.840 4,352 12.111 9.399 14,537 Tetal current assets 6292 9465 5.778 15.221 14,062 20,253 Net property, plant and equipment 17.292 19.025 25.344 28,459 29,931 39,762 Total asses 21.584 28490 34,622 43.680 43.993 60,015 Accounts payable 681 Notes payable 6323 915 7.236 964 6320 1,189 911 1,816 5.171 2,746 8,131 Current portion of long-term debe 191 318 512 3.097 2987 2,729 Total current liabilities 1,194 1,296 9,450 6,644 12,676 Long-term debt 3,000 3.153 3.291 5663 5.067 2.624 Shareholders' equity 13381 16.568 23,035 28,561 32,282 44,715 Total liabilities and equity 23.584 28.090 34622 43,680 43,993 60,015 Exhibit 1-continued ED, Inc. Selected Market Based Data (5000s) 2014 2015 2016 2017 2018 2019 End-of-year share price (S 18.13 15.91 27.25 33.30 39.96 Shares (000) 2967 2,967 2967 2967 29672,967 Eamings per share (5) 160 1.18 234 247 1.96 621 Dividends per share (5) 051 Price to earnings ratio 11.33 13.54 10.70 8.61 11.09 0.70 202 17.01 644 Beta 1.25 Exhibit 2 Selected Financial Data for Processed Food Producers Agro Blast Flash Buds Green Thumbs 2019 2019 2019 Sales (Smillions) 43 39 921 Net Income (Smillions) 7.9 7.3 45 Earnings per share $1.58 $3.66 $4.54 Total Assets (Smillions) 34 32.1 645 Accounts Payable (Smillions) 2.8 2.1 80 Notes Payable (Smillions) 4.1 4.3 95 Long-Term Debt (Smillions) 5.1 4.7 180 Stockholder's Equity (Smillions) 22 21 290 Shares Outstanding (Millions) 5 1.99 9.91 Stock Price ($) 14 31 33 Beta 1.38 1.41 1.13 Bond rating AA AA BBB Healthy Grains Macro Tastes Yummy Veggies 2019 2019 2019 Sales (Smillions) Net Income (Smillions) 2072 1364 4403 118 96 302 Earnings per share $4.57 $5.29 $2.93 Total Assets (Smillions) 1028 903 2526 Accounts Payable (Smillions) 112 97 230 Notes Payable (Smillions) 141 123 346 Long-Term Debt (Smillions) 203 195 470 Stockholder's Equity (Smillions) 572 488 1480 Shares Outstanding (Millions) 25.82 18.15 103.07 Stock Price ($) 39 35 24 Beta 0.97 0.74 1.14 Bond rating A A A Exhibit 3 Revenues Cost of goods sold Frozen Food Business Proposal -- Pro Forma Income Statement and Asset Requirements Projections 2020-2026 (S000) 2020 2021 2022 20223 2024 2025 2026 20.422 49.561 65.260 73.632 83.140 93.850 17.844 40.639 53.513 60.378 68.175 76.957 Operating Expenses Depreciation 2.246 5.452 6.199 6.995 7.898 8.915 587 554 534 525 527 538 Pretax operating profit (256) 2.915 5.013 5.733 6.540 7.439 Balance Sheet Cash 317 204 496 653 737 832 939 Accounts receivable 1.701 4.128 5.436 6.134 6.925 7.818 Inventories 1.750 3.973 7.900 10.402 11.737 13.253 14.960 Total current assets 2.067 5.879 12.524 16.491 18.607 21.010 23.716 Net property, plant and equipment 6.000 6.103 6.499 6.900 7.300 7.703 8.100 Total assets 8.067 11.982 19.023 23.391 25.907 28.713 31.816