Problem:

You work for a company that is currently considering a new manufacturing project. In detail, this project will provide a new type of economic motors for farmers. The project will require a large capital investment. Hence, you have been asked by your manager to prepare a capital budgeting analysis for this project.

The Project:

You have contacted the marketing department to ask them about the expected sale price for each motor. Three weeks later, you received an email from the head of marketing team that including a feasibility study for the project. The marketing team expects that the company can sell the new type of motors for the next 7 years, at which time it believes the motors will be obsolete.

More data for the project is listed below:

- The machinery used to manufacture the motors will be depreciated in 8 years using The Modified Accelerated Cost Recovery System (MACRS).

- Here is the depreciation schedule for 8 year MACRS:

Depreciation

Percentage

Year 1

13.25%

Year 2

25.04%

Year 3

16.44%

Year 4

14.62%

Year 5

8.44%

Year 6

8.92%

Year 7

8.83%

Year 8

4.46%

- By looking to the financial statements, we observed that the company spent $3.6 million last year on selling, general and administrative expenses. The operation department expects that the new production line will require the company to spend an additional $180,000 per year on SG&A.

- The cost of renting a space for the new manufacturing line will be $490,000.

Corporate Finance

Fall 2019

Group Project

2

Extra Estimates:

- Manufacturing Machine Cost $11,000,000

- Market Value of Machine at time 7 $1,950,000

- Sale Price Per Unit $150

- Variable Cost per Unit (VC) $70

- Fixed Manufacturing Costs (FC) $510,000

- Tax rate 35%

Sales estimates by units:

- Sales Year 1 70,000 units

- Sales Year 2 80,000 units

- Sales Year 3 90,000 units

- Sales Year 4 100,000 units

- Sales Year 5 50,000 units

- Sales Year 6 25,000 units

- Sales Year 7 22,000 units

Working capital estimates:

- The marketing department recommend to maintain inventory equal to 45% of the next years' variable costs.

- In addition, The marketing department believes credit sales are important to its business. It is expected that at the end of each year, 25% of the year's revenues will be on account. That account receivable will be collected in the next year.

- The Procurement department expects the company to receive credit terms from its suppliers to finance its inventory. At each point in time, it expects to have accounts payable equal to 40% of inventory.

Capital structure estimates:

- The finance department is looking to issue a new bond to finance this project. The company's financial advisor believes the company could sell eight-year zero coupon bond with price equal to 62.13% of par. The bond issuance will finance 40% of the new project.

- The board of directors is considering equity-rise to finance the remaining budget of the new project. The rate on the treasury bills is 1.7%. The beta for the new project is equal to 3.2. In addition, the risk premium is 6%.

Corporate Finance

Fall 2019

Group Project

3

You have to:

- Calculate the project's NPV, IRR and Payback Period using the previous inputs.

Please answer the following questions:

1. What will happen if the marketing team was not precise about the sale price. And the company will sell its motors for 10% discount.

2. What will happen if the company could finance only 20% of the total budget by issuing bond?

3. Instead of issuing bond, the company could sell preferred stocks. The sale price will be $24, and the dividend equal to $2. Would you agree in selling preferred stocks instead of bonds? and why?

Hint: RE = 60%, RP = 40%