The Santiago Project

Santiago Old Car Parts (SOCP) is considering a new venture (or project) that hopes to take advantage of the opening of business investment in Cuba. Using proprietary software, CNC milling machines, and the latest technology in 3D printing, the firm can design and fabricate affordable car parts for old, classic cars that have no other sources of parts.

The market study has been completed and the interns have made the following forecasts for the project.

Initial investment: o SOCP has found a production site and will purchase the equipment to support the project. The equipment, including shipping and installation is expected to cost (t=0) $ 7,392,000.

o The investment in Inventory needed for the project is expected to be $575,000 with an expected increase in Accounts Payable of $255,000.

o The equipment falls into the IRS 5-year class life using the MACRS depreciation

method with the 12 year convention. The IRS depreciation table is:

Year	Depreciation (% of depreciable basis
1	20.00%
2	32.00%
3	19.20%
4	11.52%
5	11.52%
6	5.76%

The program (project) is planned to continue for 9 years. At the end of the project the equipment will be salvaged (sold). The forecasts predict that the equipment can be sold then for $283,000.

The Net Operating Working Capital (Inventory and Accounts Payable) is expected to be liquidated at the end of the project (Year 9).

The project is expected to operate as a new division and the projection for new sales revenues is:

o Estimated sales in year 1:$1,750,000

o Sales are expected to grow by

25% in year 2,

25% in year 3, 15% per year in years 4 and 5, 10% in year 6, and then 5% per year thereafter.

Production cost forecasts are: o Fixedcosts:$200,000peryear. o Annual variable costs: 45% of revenue.

SOCP has a marginal (federal + state) tax rate (T) of 34%.

The firms beta is 1.41,

The risk free rate of return (rrf) = 3.25%,

The market risk premium (rm rrf) = 4.25%,

The firms analysts have partially prepared information for SOCPs cost of capital at various levels of debt and equity:

Cost of Capital & Capital Structure Worksheet

rd = before tax cost of debt, rd(1-T)=aftertaxcostofdebt, b = beta, re = cost of common equity, Wd = Weight of debt, Wce = Weight of common equity,

SOCP has the following levels of debt and common equity (market values):o Debt: $250,000,000 o Equity: $833,333,333 o Total Capital: $1,083,333,333

SOCPs management utilizes risk adjusted hurdle rates for evaluating capital budgeting projects. All potential projects are classified using a five level classification system:

Risk Level

A B C D E

Class

Low risk Below average risk Normal risk Above average risk High risk

Hurdle Rate

WACC 2

WACC 1 Equal to the WACC WACC + 1 WACC + 2

The Cuba project is considered to be High risk. Given all of the information provided in this case: (Show your work, calculations, and explain your answers well)In a Word document:

What is the firms current Weighted Average Cost of Capital (WACC) at its current capital structure.

Capital Structure theory addresses finding a firms optimal capital structure. How do you determine the optimal capital structure?

What is the SOCPs optimal capital structure? (Complete the Cost of Capital & Capital Structure worksheet)

Define Hurdle rate. Based on SOCPs current capital structure, what is the appropriate Hurdle Rate for the Cuba project?

Starting with a blank Excel workbook:

Please complete the capital budgeting analysis for this project. You should develop the incremental cash flows:

o Initialinvestmentcashflowatt=0, o Operatingcashflowsthroughthelifeoftheproject,o Terminalcashflows

You should evaluate the project using:o NetPresentValue,

o InternalRateofReturn,

o ModifiedInternalRateofReturn

Present your decision whether the project should be accepted or rejected, and justify.

Cost of Capital & Capital Structure Worksheet D/A E/A rd( 1-T 0.00% 315% 3.47% WACC 8.252% 783 % D/E 0.000 0.231 1.18 1.41 1.000 0.769 0.00% 477% 525% 675% 8.25% 92910 0.30 0.50 0.429 1.76 0.571 Cost of Capital & Capital Structure Worksheet D/A E/A rd( 1-T 0.00% 315% 3.47% WACC 8.252% 783 % D/E 0.000 0.231 1.18 1.41 1.000 0.769 0.00% 477% 525% 675% 8.25% 92910 0.30 0.50 0.429 1.76 0.571