Question

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 isnotincluded 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

Questions:

a.)What must be the current market price (in ) of one of SB's outstanding bonds? Show your calculations.

Answer:

Bond Price =

b.)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 =

c.)What is the cost of equity for project Schwein? Show your calculations.

Answer:

Cost of Equity =

d.)What are SB's capital structure weights? Show your calculations.

Answers:

D/V =

E/V =

e.)What isthe weighted average cost of capital (WACC) for project Schwein?Show your calculations.

Answer:

WACC =

f.)What is the depreciation schedule in each of the next three years for the equipment SB needs to buy? Use the template below.Show your calculations.

Year t

Book value at the beginning of the year

Depreciation

Book value at the end of the year

1

2

3

g.)Complete the pro forma income statement for project Schwein. Use the template below. Specify the variables you use in the first column. (Note: there may be more rows than you need). Given that you are constructing the income statement for the purpose of a project evaluation, should you include interest expenses in your calculations? Why or why not? If your answer is no, how is the debt tax shield (the tax liability as a result of holding debt) accounted for?

Year 1

Year 2

Year 3

Sales Revenue

Cost of Goods Sold (aka Variable cost)

Fixed Costs (Overhead)

h.)What are the operating cash flows for project Schwein? Use the template below.

Year 1

Year 2

Year 3

EBIT

+ Depreciation

- Taxes

= OCF

i.)What are the additions to Net Working Capital? Use the template below. (Note: there may be more rows than you need).

Year

Sales

Net Working Capital

Additions to NWC

0

1

2

3

j.)Calculate the project cash flows for project Schwein. Use the template below. (Note: there may be more rows than you need).

Year

Operating Cash Flow

Additions to NWC

Net Capital Spending

Total Project Cash Flow

0

1

2

3

k.)What is the NPV of this project?If your goal is to maximize the wealth of SB's shareholders, should you take this project on? Why or why not? (Hint: Adjust your cash flows for the possible expropriation in year 3. In addition, consider the taxes Germany charges on repatriated profits and adjust your cash flows accordingly).

Answers:

NPV =

Accept:YES/ NO,

because: