It is October of 2020, and Dothraki Industries is examining a capital investment proposal that involves investment in a series of machines that would greatly increase the production of one of the company's main products, Dragonglass weaponry.

Company Background

Dothraki Industries was established in the early 2000s for the purpose of manufacturing and forging high quality Dragonglss products with a specialized niche in the production of custom forgings for the agricultural, construction, and defense industries. Dothraki has the advantage of in-house forging and heat-treating departments, along with access to the highest quality of raw materials, which allowed Dothraki to develop a variety of innovative forged products. Within a few years, the company was distributing forged products across the world. including the continents of Westeros and Essos.

Investment Proposal

The proposal involves investment in a group of machines that would greatly increase the firm's ability to manufacture large quantities of Dragonglass weaponry, including spears, knives, and hatchets. The purchase price of this machinery would be $6,000,000. The equipment would have a useful economic life of 6 years, and for tax purposes, depreciation charges would be $1,500,000 per year over 4 years to a book value of $0. It is anticipated that the variable operating costs, excluding depreciation, will be approximately 50 percent of sales. In the project's first year, incremental fixed costs (maintenance, etc.) are projected to be $500,000. In each of the remaining years, this fixed cost component is projected to increase by 8% over the preceding year. Interest charges associated with the financing of this investment have been estimated at approximately $150,000 per year, for each year of the project's estimated useful life.

The projected sales revenue from the project are listed in Exhibit 1 below, and all of these sales are expected to be incremental sales for the firm with no side effects on other Dothraki products.

Samwell Tarly, the firm's accountant, pointed out that this project would not be happening if not for the special feasibility study performed by the Citadel Consulting Group. The study was commissioned and paid for last year at a total cost of $480,000, and it confirmed the efficiency and effectiveness of Dragonglass weaponry in eliminating household pests and invaders. Sam also mentions that Dothraki expects to have plenty of taxable income from other projects in the foreseeable future, so any losses generated by the project could be used to offset other taxable income.

In addition to the initial outlay for the machinery, the firm anticipates that it will have to make incremental working capital investments to parallel the expected changes in sales reported in Exhibit 1. Based on financial analysis, it has been agreed that an appropriate estimate of a proper working capital requirement figure would be 10 percent of incremental sales (i.e., the NWC investment (or recovery) at time t will be 10% of the change in sales between time t, and t + 1, and the NWC investment at time t+1 will be 10% of the change in sales between time t+1 and t+2). All NWC for the project will be recovered at the end of the project (t=6), and Dothraki management expects the machinery to be sold for a before-tax scrap value of $400,000 at the end of year 6.

The CFO of Dothraki Industries, Arya Stark, requests your assistance in preparing an analysis of the decision of whether or not to purchase the machine. In performing the analysis, Ms. Stark would like to see estimates of net cash flow projections for the project, along with the NPV, IRR, and your recommendation. As part of the analysis, Ms. Stark has informed you that she believes that the risk of this project is of similar risk as the average risk for the firm and therefore you may use the firm's Weighted Average Cost of Capital (WACC) as the appropriate discount rate. She has also informed you that the tax rate to use for the WACC and the capital budgeting analysis is 20%.

Dothraki has 50,000,000 shares of common stock outstanding that are trading for $29.70 per share. The company's beta is 1.4. Financial analysts estimate that the market risk premium over 10-year Treasury Bonds is 6 percent and 10-year Treasury Bonds currently yield 2%. Dothraki's outstanding bonds have a 6.0% coupon rate, a $1,000 face value, pay semi-annual coupons, and mature in 10 years. There are 450,000 of these bonds outstanding and they are currently selling in the open market for 110% of par value.

The details of your relevant cash flow projections (Operating Cash Flow, Capital Spending, Net Working Capital, and Total Cash Flow) should be clearly presented along with the NPV and IRR in the response of answers, along with your final recommendation.

Sales Revenue Projections

Year 1 = 4,000,000

Year 2 = 4,000,000

Year 3 = 5,000,000

Year4 = 5,000,000

Year 5 = 6,000,000

Year 6 = 6,000,000

A. What is the WACC for Dothraki for this project?

B. What are the relevant total net cash flows for the investment decision for each year including the initial investment at t=0? (This is not intended to trick you - just provide the relevant cash flow calculations by year!)

C. What is the NPV and IRR for this project? If you did not estimate a WACC in part A, use a discount rate of 10% for your NPV calculation.

D. Should Dothraki pursue the project? Justify your answer.