Question
Lululemon is considering a new project that improves inventory management for the next 5 years. The project has similar risks as the overall firm. The
Lululemon is considering a new project that improves inventory management for the next 5 years. The project has similar risks as the overall firm. The new technology will require an investment in computer and robotic equipment of $4 million (t=0). The machines will be depreciated on a straight-line basis to 0 over 5 years. At the end of the project, the company expects that they will be able to sell the used machines for $1 million. To operate the machines, each year there will be a fixed cost of $100,000. The benefit of these machines is that they will reduce the inventory (ie Net Working Capital) of the company by $7 million dollars during the time that the machines are in use (starting at year 1). There is no gain in operating revenues from these new machines. The tax rate for the company is 20%.
Based on historical company information, you estimate that the cost of equity for Lululemon is 14% and the cost of debt is 6%. The company has maintained a debt-to-equity ratio of 1:2.
Q1) What are the FCFs for the project for years 0 through 5? [If you have trouble with FCF, make up FCF for each year then continue with the other questions.]
Q2) If the project is financed using the same capital structure as the firm, what is the NPV of this project?
Q3) If the project is all equity financed, what is the NPV of this project?
Q4) Instead of maintaining a constant capital structure for the project, the company chooses to finance the initial cost of the investment with debt ($5 million) and will keep this debt for the duration of the project (it will be paid off in year 5). Assume the cost of debt and interest rate on debt are both 6%. What is the NPV of this project under this alternative financing option?
Q5) Another alternative option is to finance the project at the debt-to-equity ratio of 1:1. Assuming they maintain this debt ratio for the duration of the project, what is the NPV under this financing option?
Bonus) Under the financing option in Q4, what is the level of debt at the end of year 2?
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