Pacific Books (PB) is a publishing company that is considering a four-year expansion project into educational services. The company already paid $0.5 million to a consulting company to advise on the expansion project. This expense will be capitalized and depreciated over the next four years. The current capital mix of PB is 20% debt and 80% equity. The debt is rated A, which has a 2.00% spread over risk free rate. Risk free rate is currently 2.10%. Equity beta in publishing business is 0.80 and 1.15 in educational services business. The company’s finance department uses market risk premium of 4.5% in estimating the cost of equity and the company pays 24.0% marginal income tax rate. The expansion business will require $8.0 million investment – this investment will have the same 20/80 mix of debt and equity as the existing PB capital. The investment will be depreciated straight line over the next four years at $1.2 million annually. The company is expected to recover 50% of the remaining book value at the end of the project. The project is expected to generate $7.0 million of revenue in each of the next four years. The company’s SG&A expenses will increase from $5.0 million to $7.0 million annually to accommodate for additional staff to run the project. Additionally, the company will use the excess space in the building it already owns to provide educational services. While the company did not have plans to rent the extra space, the cleaning and other maintenance expenses are expected to go up from $200,000 to $800,000 annually to accommodate educational services. Net working capital to support the project is expected to be 15% of revenue at the beginning of each period and will be fully recovered at the end of the project. The company will need to spend $1.5 million at the end of the project to return the building to its original condition.

1. Calculate the discount rate for this expansion project (5 points)

2. Calculate incremental cash flows of the project (15 points)

3. Calculate NPV, IRR and payback for this project (15 points)

Part II Now assume that the company is considering another, mutually exclusive investment the PB can make into the existing publishing business. This project will require an initial investment of $10 million and will generate a $3.5 million in free cash flows for the next six years. Again, as in the project in Part I, the financial mix of debt/equity will not change.

1. Calculate the WACC and the NPV of this project (10 points)

2. Which project should Pacific Books undertake – in Part I or in Part II? (5 points)