Question
You are the Capital Budgets Officer of Great Big Enterprises Inc. (GBEI), which is headquartered in Saint John, New Brunswick. The conglomerate company has three
You are the Capital Budgets Officer of Great Big Enterprises Inc. (GBEI), which is headquartered in Saint John, New Brunswick. The conglomerate company has three major divisions, a trucking division, an aquaculture division, and a lumber products division, as well as a number of projects in other areas. GBEI is financed with 30% debt and 70% equity. GWEIs average cost of debt is 9% and its corporate tax rate is 30%. You forecast that the rate of return from one-year Treasury bills will be 5% in the next period and the rate of return from the stock market will be 13%.
You have been asked to conduct an evaluation of the following two investment projects:
Alternative #1
This alternative involves the purchase of a lumber mill operation located in Nova Scotia. You have estimated the initial investment as $1,000,000 and the annual pre-tax cash flow over the next 10 years as $200,000 at which point the operation will be obsolete. If GBEI decides to invest in the lumber mill operation, it will be financed using the same proportions of debt and equity that GWEI currently uses. You have collected information on a publicly-traded lumber products company whose primary line of business is similar to GBEIs lumber mill operation. The information gathered implies systematic risk (beta) of 1.05. Assume straight line depreciation.
Alternative #2
This alternative involves purchasing new aquaculture equipment for $500,000, with a forecasted useful life of 10 years, to replace old equipment that could be disposed of at an estimated salvage value of $60,000. If GBEI acquires the new equipment, it could take on a bigger service area that was not previously feasible, thus leading to an annual increase in sales of $200,000. With the improvements in technology built into the equipment, GBEIs annual operating expenses would be reduced by $100,000. Operation of the new equipment would require GBEI to maintain inventory levels $100,000 higher than usual over the life of the project. The new equipment could be sold at the end of its useful life for $40,000. This project will be financed using 50% debt thus it warrants a project beta of 1.50 given its riskier profile. Assume straight line depreciation. Assume gross margin on incremental revenues is 60%.
A. Calculate the following to be used in evaluating the purchase of the lumber mill operation and the aquaculture equipment:
Cost of equity
Weighted average cost of capital
B. Calculate the NPV, IRR, Payback Period, Discounted Payback Period and Profitability Index of the lumber mill operation.
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