You have been asked to analyze whether Telco Inc, a computer manufacturer, should invest in producing new software.

Telco has already spent $ 3 million developing pieces of the software; this expense was capitalized and will be depreciated straight line over the next four years.

Telco will have to invest an additional $ 7 million if it wants to commercially develop the software, and this investment will also be depreciated straight line over four years to a salvage value of $ 1.5 million at the end of the 4th year.

Based upon a market study, Telco concludes that it can generate revenues of $ 7 million every year for the next 4 years; operating expenses (other than depreciation) are expected to be 55% of revenues each year.

Telco does not expect its overall annual G&A expenses, which are $6 million, currently to change as a result of investing in the software business, but it plans to allocate 10% of these expenses to this project.

Telco has an unlevered beta of 0.90 (bottom-up beta for computer manufacturers) but the unlevered beta for computer software companies is 1.35 The market value of equity for Telco is $ 100 million and the market value of debt is $ 50 million. Telco plans to maintain this debt to capital ratio for this project. Telco is BBB rated and the default spread on BBB rated bonds is 2%. The riskless rate is 4% and the market risk premium is 5%. The tax rate is 40%.

a. Estimate the cost of capital for this project.

b. Estimate the incremental cash flows on this project.

c. Estimate the net present value of this project.

a.

a) WACC = 9.37%

b) FCFF = -5 ; 3.44 ; 3.44 ; 3.44 ; 2.44 (in millions)

c) NPV = 2.35 (in millions)

b.

a) WACC = 10.37%

b) FCFF = -7 ; 2.44 ; 2.44 ; 2.44 ; 3.44 (in millions)

c) NPV = 1.35 (in millions)

c.

a) WACC = 12.78%

b) FCFF = -10 ; 1.44 ; 1.44 ; 1.44 ; -0.44 (in millions)

c) NPV = -0.35 (in millions)