Problem Information:

As of late 2019, Toyota Motor Corporation has twelve engineering and manufacturing facilities in the United States. Recently, Toyota has been considering expanding the production of their gas-electric hybrid drive systems in the U.S. To enable the expansion, they are contemplating investing $1.5 billion at the end of 2020 (Year 0) in a new plant with an expected 10-year life. In the meantime, they also need to invest $30 million upfront in net working capital before the production can take place.

The projected financials of the new project for the Year 1 operation (2021) are as follows:

Earnings before interest and taxes (EBIT): $170 million Depreciation expense: $150 million Increase in net working capital: $40 million

The anticipated unlevered free cash flows from the new plant will grow by 5% for each of the next two years (Years 2 and 3) and then 2% per year for the remaining seven years. As a newly hired MBA in the capital budgeting division you have been asked to evaluate the new project using the WACC method. You will estimate the cash flows and compute the appropriate cost of capital and the net present values. You must seek out the information necessary to value the free cash flows but will be provided some directions to follow. Assume that marginal corporate tax rate is 40%.

Question:

The case uses the 10-year treasury yield as the risk-free rate. What is the rationale behind this choice?