1

Subject:Health SciencePrice:4.89 Bought3

Share With

1. The management of East Side, Inc. is preparing its capital budget for 2015. East side has two divisions. One runs a restaurant (the Restaurant Division). The other brews beer (the Brewery Division). Most of the analysis for 2015 projects has been completed, but some refinements are needed in the analysis of one more project.

This project is one that is expected to have no impact on sales revenue, but reduce costs in the Brewery Division. The capital investment for equipment required for the project in question is $200,000. Setup costs associated with the new equipment are expected to add another 15 percent to the initial investment amount. Management believes that the investment and expenses associated with buying and setting up the equipment will be depreciated using straight-line method. The equipment is expected to have a five-year operating life. At the end of that period, the machinery is expected to be sold for $15,000.

Management expects the total projected sales revenue in the Brewery division in 2015 to be $1,000,000 and revenues are expected to grow by 5 percent per year for the next four years due to inflation.

The expected benefits of the new equipment are twofold. First, management expects to reduce direct labor costs by a total of 8% of total sales revenue each year for five years. Second, management believes that the new machine will reduce hops used in the manufacturing process by 2000 pounds per year. Each pound of hops costs $5. The nominal price per pound is not expected to change.

The new machinery is very sensitive to the intensity with which it will be used and might require extensive annual maintenance. Management is not exactly sure how to estimate the maintenance expenses, but is sure that whatever they are, they will be treated as a tax-deductible expense in the period in which they are incurred.

After careful discussion with the equipment vendor, management has concluded that there is a 20 percent probability that the machine will be used so extensively every year during its five-year life that it will require the maximum maintenance. The cost of the maximum maintenance will be $50,000 per year before tax. There is a 50 percent chance that its usage will result in a $30,000 annual maintenance expense. Further, management believes that there is a 30 percent chance that it will be used in such a way that annual maintenance expenses will be only $10,000. The nominal cost of maintenance is not expected to change.

In addition to labor savings and quality improvements, management believes that the new equipment will enhance working capital productivity. Specifically, management projects that the firm’s required investment in work-in-progress inventory will decline from 20 percent of sales to 15 percent of sales.

The CFO has indicated that regardless of the source of financing used, the nominal after tax cost of capital for all projects considered by the brewery is 10% for the foreseeable future. Also, a tax rate of 35 percent should be used in all analyses.

Should the company invest in the labor saving equipment?

       __________________

2. When preparing capital budgeting analysis for a new project, Chris Johnson, a chief financial officer at BT Industries, faced a dilemma. The project involved a production of new type of shipping containers, which were significantly more durable and had a considerably longer useful life compared to conventional containers used in the industry. The year was 2009, and the equipment necessary for producing the containers was being sold for $900K. Each year, this cost is expected to increase by 20%. The useful life of the equipment and the project is 5 years. Mr. Johnson estimated that during a good year, the project will generate net cash flows of $600K per year, while during a bad year, the project will lose money, with an expected net cash flow of $-200K per year.

Because the economy suffered a significant decline just a year prior, there was uncertainty about the economy in general, and, very much affected by the economy, the demand for shipping and containers. Market analysts predicted that uncertainty will remain in 2010 and at this point, in 2009, the likelihood of 2010 being a good year is estimated at 40% and the likelihood of 2010 being a bad year is estimated at 60%. However, all uncertainty will get resolved in 2011. The likelihood of 2011 and all subsequent years being good years (recovery) is 30%, and the likelihood of these subsequent years being bad years (recession) is 70%.

Since he has not dealt with uncertainty regarding the future state of the economy before, Mr. Johnson is bewildered and asks your help in determining the course of action regarding this opportunity. Mr. Johnson has estimated that the WACC for the company in certain times has been 10%. Assume that the project has no tax implications, i.e. the tax rate of 0%.

• a)  What is the NPV of investing into the machine in 2009? __________________
• b)  What is the NPV (in year 2009) of delaying the investment until 2010? __________________
• c)  Should the firm invest in the project in 2009, 2010, or not invest at all? __________________
• d)  Assume that the firm has the possibility to invest in 2009 only. What is the value of knowing in 2009 with certainty the state of the world in 2010, with regards to this project? In other words, what is the maximum amount of money the company would pay to know in 2009 whether 2010 would be a good or a bad year? Explain your answer. ?       __________________
•  

3. Assume that a company is expected to produce EBITDA of $90M in perpetuity. The corporate tax rate the company is subject to is 35%. To maintain the existing production capacities, capital expenditures are expected to be at $10M per year, in perpetuity. Annual depreciation, expected in perpetuity as well, is $10M. The current risk-free rate is 3%, and it is expected to remain so in perpetuity. The company has $200M in long-term debt, which is considered by the bank to be risk-free, so the interest rate the firm pays on its debt is 3%. The company expects to hold that amount of debt in perpetuity. Using stock returns on a comparable company that operates in the same industry, and has debt outstanding equal to 40% of the market value of its total capital, analysts estimated that the comparable company’s beta is 1.8. The analysts believe the companies are comparable in all respects except for the capital structure, and do not expect that beta to change over time. You also know that the estimate of the market risk premium for the foreseeable future is 5%.

• a)  Please calculate the value of the firm’s equity. __________________
• b)  Please calculate the weighted average cost of capital (WACC) the firm should use when evaluating new ?projects in its industry. ?       __________________
•  
• c)  Please calculate the firm’s earnings per share. __________________ ?Assume that the firm decided to issue additional debt in the amount of $150M. Also assume that the risk of ?the firm’s debt would not change due to the issuance of new debt.
• d)  What do you expect the value of the firm’s equity to be if the company were to issue new debt and use the ?proceeds from this debt issue to repurchase equity? ?       __________________
•  
• e)  Please calculate the new, post-restructuring WACC. __________________
• f)  What price per share would the firm repurchase the equity at? Please explain your answer. ?       __________________
•