QUESTION 2.

Dunder Mifflin is a paper manufacturer and distributor which is investing in a new line of paper. The company needs to buy the building for US$50 million and make an initial investment of US$30 million to convert the building into a plant. Expenses are incurred today (t=0). 10 years is the expected life of the plant. The company is estimated to make sales of 1 million units per year for all of the 10 years. Fixed costs and variable costs are US$10 million each year and US$20 per unit (one ream) respectively. The companys executives have decided to set a sales price of US$30 per unit. Assume that people who buy the new paper would be new customers, i.e. introducing this paper to the market would not affect the sales of their other products. All the expenditures made for the plant today will be depreciated straight-line over 10 years (from year 1 to year 10) leaving behind a value of US$5 million, but the company believes it might be able to sell it off at US$10 million.

The company has a beta of 1.75; it is 60% financed by debt, and debt holders require a 10% rate of return on their investment. Taxes are 40%. The interest on short-term government bonds is 4%, while the market rate of return is 8% and is expected to continue.

1. What is the expected return on Dunder Mifflins stock?

2. What is the weighted average cost of capital for Dunder Mifflin?

3. Determine the free cash flow for years 1 to 10 by taking into account all the cash flow components needed.

4. What is the projects NPV under the given assumptions? Should Dunder Mifflin invest in the project?

5. Apply a financial breakeven analysis to check whether you get the same result about this being a good or bad project.

i. First, hold everything constant but the units of paper sold. At what number of units sold would the project break even?

ii. Suppose you are uncertain about how many units will be sold. Allow a 30% deviation (up and down) from your original estimate of units sold. Is this project still profitable?