You've just started an internship at your dream company, "Ice-Cream Factory"! All that's left to do is impress your boss with your knowledge of corporate finance, do your job right, so your boss quickly realizes you are a keeper and offers you a full-time job! So, let's get to work!! You were immediately assigned a big project. You were asked to do some research, crunch some numbers, and propose a recommendation for a new project: opening a new location near Cal Poly Pomona campus. Should the project be accepted or rejected? First, you need to analyze the market. "Ice-Cream Factory" is an all-equity company. Its market value is $25 million. It has two other competitors in the market: "Ice Paradise". Its market value equals $15 million. Its equity Beta equals 1.23. "Ice, Cone, and Beyond". Its market value equals $10 million. Its equity Beta equals 1.07. Both are also unlevered. Treasury bills are viewed as the riskless asset in the market. Standard & Poor's 500 index reflects the performance of 500 largest companies and therefore represents the market. Your economic data analysis makes you believe that there are three equally likely states of the economy for the future years. See details in the table below: State of the economy #1 State of the economy #2 State of the economy #3 Treasury bill rate 3.80% 3.80% 3.80% Standard & Poor's 500 index return 7.00% 11.00% 22.00% For all calculations below: notice that all percentages need to be in percent, not in decimals, and rounded to two decimal places. Also, use 0 for any blank values. Increase the decimal places for all intermediate calculations. HINT: one number given in this problem will not need to be used. You used the Capital Asset Pricing Model to figure out the required return on the new project of "Ice-Cream Factory". The company is planning to cover the cost of starting the new project with equity raised externally. The project's estimated equity Beta equals 1.64. Here are your calculations of the required return for the new project: Rf + x (E(RM) - Rf) __ __. __ __ % + __ . __ __ x ( ___ ___ . ___ ___ % __ __ . __ __ %) which gives (__ __ . __ __ )% You believe that the systematic risk of "Ice-Cream Factory"'s equity correctly reflects the average systematic risk of its competitors that correctly takes into account their relative sizes. This allows you to calculate "Ice-Cream Factory"'s Beta. It equals _____ . _____ ______. Finally, you were able to calculate the cost of "Ice-Cream Factory"'s equity that correctly compensates investors for the amount of systematic risk. It equals (__) . (__) %. 2. Let's say, in Part #1 you got the following results (you may need some of them to solve Part #2) : All-equity "Ice-Cream Factory" Firm's Beta is 1.15 "Ice-Cream Factory" Firm's cost of equity is 11.15% "Ice-Cream Factory"'s new project's Beta is 1.35 "Ice-Cream Factory"'s new project's required return is 12.45% The next step of your project valuation assignment is to use all relevant information available to make your recommendation regarding the new project: is it worth investing money into or not? So, you rolled up your sleeves! You're ready to work hard!! You know that there are different ways that project could be evaluated. You will use the method known as the Net Present Value technique. Here's the information you will use: It will be an 8-year project. If the project is looking profitable, then "Ice-Cream Factory" will need to make a large upfront investment in the amount $2,450,000. This will cover the purchase of a building all all the necessary equipment. You looked up the economic life of these assets, and looks like they conveniently all have the same economic life of 15 years. They will be losing the same value every year once they are purchased, all the way to zero value at the end of their economic life. At the end of the project, you estimate that "Ice-Cream Factory" might be able to sell these assets for 45% of their original purchase price. Based on the presence of local competition, local consumers' spending habits and average household income, you believe that "Ice-Cream Factory" would be able to sell approximately 400,000 ice-creams and other products each year, for an average of $5 a piece. It will cost $3.50 to produce each, which includes buying raw materials, paying hourly wages, costs of utility bills, etc. Taxes are separate. "Ice-Cream Factory" falls into 35% tax bracket for all purposes. "Ice-Cream Factory" would also need to immediately set aside cash in the amount of $320,000, and this cash reserve would be increased by $35,000 each year to cover any potential increased repair costs that might come up over the project's life. So... Now, you need to organize all this information! For all calculations below: Increase the decimal places for all intermediate calculations. This will help you to not miss points due to rounding errors. Round all dollar amounts that you fill into the fields to WHOLE number. Do NOT use the "$" signs. Type 0 for any blank values. If your value indicates a cash OUTFLOW, don't forget to put the minus sign! Otherwise, for all cash INFLOWS, type your value with no sign. Fill out the table below! HINT: You should have 2 zeroes in this table! Beginning of the project (Year 0) End of Years 1 ~ 7 End of the project (end of Year 8) Operating Cash Flow $ $ $ Net Capital Spending $ $ $ Change in Net Working Capital $ $ $ Phew!!!... Almost there!... Now, all that's left is putting it all together. Your estimated Net Present Value of this project is $, and so when you are presenting a report with your analysis of the project to your boss your recommendation will be to (type accept or reject) this project. 3. Let's say, in Parts #1 and #2 you got the following results (you will need some of them to solve Part #3) : Treasury bill rate is 3.00% All-equity "Ice-Cream Factory" Firm's Beta is 1.15 The eight year project requires $2,300,000 to be spent on the initial investment (equipment, and other fixed assets) Expected return on the market is 11.00% "Ice-Cream Factory" Firm's cost of equity is 12.20% The estimated Net Present Value equals -$29,223. It is based on the following estimated total project cash flows: "Ice-Cream Factory"'s new project's Beta is 1.35 Total project cash flow in Year 0 is -$2,900,000 "Ice-Cream Factory"'s new project's required return is 13.80% Total project cash flow at the end of Years 1 through 7 is $550,000 Total project cash flow at the end of the final Year is $1,400,000 All income is taxed at 35% tax rate You were about to give your written report to your boss when you remembered that you learned something important in one of your finance classes in college! A project's value might be very different when a loan is used to cover part of the initial investment! And so you decided to go home, crunch more numbers, and turn in your written report in the morning. You believe that it might be a good idea to finance 60% of the initial investment (equipment, and other fixed assets) with debt. The debt would be free of risk and therefore have the same interest rate as that for the risk-free asset. The debt will take a form of interest-only bonds, which means they require interest to be paid over their life and the principal to be paid in full at maturity. For all calculations below: Increase the decimal places for all intermediate calculations. This will help you to not miss points due to rounding errors. Round all dollar amounts that you fill into the fields to WHOLE number. Do NOT use the "$" signs. If your value indicates a cash OUTFLOW, don't forget to put the minus sign! Otherwise, for all cash INFLOWS, type your value with no sign. HINT: The 2nd and the 3rd digits of your loan amount should be "3" and "8". You used the Adjusted Present Value method to estimate the levered project's value. Your estimated annual tax savings from interest payments on the loan equal $ per year. Altogether, in today's dollars, those are worth $. Finally, your estimate of the adjusted Net Present Value of this project is $. And so, tomorrow morning, when you are presenting a report with your sophisticated analysis of the project to your boss, your recommendation will be to (type accept or reject) this project. 4. Let's say, in Parts #1, #2, and #3 you had the following results (you will need many of them to solve Part #4) : Treasury bill rate is 4.00% All-equity "Ice-Cream Factory" Firm's Beta is 1.34 If no loan is used, the nine year project requires $2,450,000 to be spent on the initial investment (equipment, and other fixed assets) Expected return on the market is 11.00% "Ice-Cream Factory" Firm's cost of equity is 13.38% If no loan is used, the estimated Net Present Value equals -$141,418. It is based on the following estimated total project cash flows: "Ice-Cream Factory"'s new project's Beta is 1.56, if no loan is used If no loan is used, the total project cash flow in Year 0 is an outflow of $2,450,000 "Ice-Cream Factory"'s new project's required return is 14.92%, if no loan is used If no loan is used, the total project cash flow at the end of Years 1 through 8 is $440,000 If no loan is used, the total project cash flow at the end of the final Year is $1,150,000 All income is taxed at 40% tax rate You are analyzing the possibility that 75% of the initial investment will be covered with a riskless interest-only loan In the middle of the night, when you thought you'd be done with all your sophisticated analyses of the project's information, you realized that you could incorporate the loan information into the project valuation differently! Under this second approach, one can look at all the cash flows from the equity-holders' perspective: when all the required cash flows to/from the lenders are considered, how much do the equity-holders get from this new project? In other words, what are the equity-holders' cash flows? For all calculations below: Increase the decimal places for all intermediate calculations. This will help you to not miss points due to rounding errors. Round all dollar amounts that you fill into the fields to WHOLE number, and do NOT use the "$" signs. If your value indicates a cash OUTFLOW, don't forget to put the minus sign! Otherwise, for all cash INFLOWS, type your value with no sign. Round all percentages and Betas to the 2nd decimal place. HINT #1: The 2nd and the 3rd digits of your loan amount should be "8" and "3". HINT #2: Some of the numbers you need to fill out are already given. HINT #3: If applicable, for the debt-to-equity ratio use debt-to-book-value-of-equity rather that debt-to-market-value-of-equity. Your estimates show that every year equity-holders will be missing out on a lot of money in the presence of this loan. Here are your recalculated total project cash flows faced by the equity-holders: (Round to whole dollar, and do not use the "$" sign.) Beginning of the project (Year 0) End of Years 1 ~ 8 End of the project (end of Year 9) Total project cash flow $ $ $ Also, you put together the following results in a more organized way: (Round all four to 2 decimal places. Notice that the returns should be in percent, not in decimals.) For this new project, the Beta of equity is: For this new project, the required return to the equity-holders is: If no loan is used for this new project % If the 75% loan is used for this new project % Finally, your estimate of the Net Present Value of this project recalculated for this case is $. And so, tomorrow morning, when you are presenting a report with your sophisticated analyses of the project to your boss, your recommendation based on this approach will be to (type accept or reject) this project