Martha S. Wine, president of "Santa Boarito Rural Pig Farms" (SB), located in the US, is facing a bit of a crisis.The company specializes in selling equipment to pig farmers in continental Europe and its major competitor has recently launched a major advertising campaign that has been cutting into sales.Martha has decided to get down and dirty and fight back.She is considering a new project that will revolutionize farming.SB has developed a machine that catches eggs laid by chickens and moves them along a conveyor belt to a feeding station where pigs can eat the eggs.SB wants to market the idea to farmers on the basis that they can sell their pigs as "Bacon and Eggs".Martha S. Wine hopes that the Bacon and Eggs project will provide SB with windfall profits.They have dubbed the three-year project "Schwein".You know the following:

A.The

production for project Schwein is to take place at the firm's subsidiary in

Schweinfurt, Bavaria, Germany.

B.Compared

to the US, the pig farming industry in Germany is small and the only firms in

the industry are all privately owned. As a result, you are unable to directly

obtain an industry beta for the pig farming industry in Germany.

C.Because

SB only recently went public (its IPO was roughly 6 months ago), there is

insufficient return data for you to come up with a reasonable estimate of SB's

equity beta.Instead, you can use information on the firm's competitors as

a basis for your beta estimation (no additional risk adjustments are

necessary). You observe that:

Competitor A Competitor B Competitor C

Equity ($m) 1,390 180 400

Debt ($m) 500 200 1,200

Total Capital ($m) 1,890 380 1,600

Equity Beta 0.5 0.6 1.4

You assume that firms in the German pig farming industry are financed similarly to SB's US

headquarters.

D.In the past three years, the US and German stock markets have been fairly highly

correlated (correlation coefficient = 0.7). The standard deviation of German

returns was 20% during that time period. You believe that both of these figures

will remain unchanged in the coming 3 years.

E.The equipment needed for Schwein costs 3,300,000 in year 0. The firm employs a

straight-line depreciation method whereby every year it depreciates 33.33% of

the equipment's book value. The firm estimates that the equipment has no

salvage value at the end of the third year.

F.The firm estimates that it will sell 500 machines in the first year, 700 in the

second, and 600 in the third.Each machine will be priced at

15,000.Each machine will cost the firm 7,000 to produce.In

addition, SB will have overhead costs of 200,000 per year.

G.SB

has no room in their current German factory to place the new equipment so they

are planning on renting a 25,000 square foot warehouse from a local real estate

development family, the Halsabschneiders.The cost for the warehouse is

300,000 per year in year 1 and will increase by 12% per year

afterwards.This cost is not included in the overhead costs in part F.

H.Project Schwein will require that the firm increase net working capital (NWC) by

300,000 immediately and then maintain a balance equal to 10% of sales.At

the end of the project, SB will recover all NWC (with no loss or gain).

I.An outside consulting firm, Lomax and Co., conducted an 18 month marketing

research study to determine whether consumers would purchase "Bacon and Eggs"

in a single meat product.The cost to SB for the study was $400,000.To date, SB has only paid Lomax and Co. $320,000 and the remaining $80,000 is due at the end of the next year.

J.You know that the firm is currently at its target capital structure.

In addition, you have the following selected information about SB from their most

recent balance sheet.

(numbers in $ millions) Year 2019

Total

Assets 830

Liabilities:

Current Portion of Long Term Debt 0

Long - Term Debt 500

Equity:

Paid in Capital 280

Common Equity 50

K.The company has one German bond issue outstanding.Eight years ago, they

issued 30-year bonds with a face value of 1,000.The firm originally

issued 400,000 of these bonds but repurchased and retired 100,000 of them in

the last three years.The bonds have a face value of 1,000.The

current yield to maturity on these bonds is 7.8702% and each bond pays a

semi-annual coupon of 42.

L.The firm has 5,000,000 shares outstanding which currently sell for $100 per share.

M.The risk free rate in both Germany and the US is 4%. You further know the following

forecast (on which all investors agree) of the returns on the US market

portfolio.The forecast is expected to remain unchanged each year for the

next 3 years.

Probability Return on the market

0.2 -4%

0.5 15%

0.3 30%

N.The firm has a tax rate of 35% in both Germany and the US.

O.You recently observed that a new party, the so-called V-Partei³, was founded in Germany (https://en.wikipedia.org/wiki/V-Partei3). You are concerned that if the party

gains power during the upcoming Bavarian elections in 3 years, it will

immediately (in year 3) expropriate your new factory and that all equipment,

inventory, etc. will be lost. You expect the chance of this event (the combined

likelihood of the election outcome and expropriation) to be 10%.

P.As a result of its ongoing tariff dispute with the US, Germany's government has

recently passed legislation whereby it imposes a tax of 20% on any repatriated

profits to the US.

Q.You observe the following information on the spot exchange rates and forward rates

between the Euro and the US dollar:

Spot rate: US$/ 1.40

1-Year forward rate: US$/ 1.50

2-Year forward rate: US$/ 1.60

3-Year forward rate: US$/ 1.70

Question 2:

Estimate an appropriate equity beta for project Schwein. (Hint: First, use the arithmetic average of the competitors' relevered equity betas as a proxy for SB's equity beta. Second, adjust the US industry beta with the information you have on the German and US stock markets to obtain a German industry beta for the project.). Show your calculations.

Answer:

SB's US Equity Beta = ?

German Industry Beta = ?