Investment Valuation and Decision Making

Part 1

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Respond to the following scenario with your thoughts, ideas, and comments. Be substantive and clear, and use research to reinforce your ideas.

Mary Francis has just returned to her office after attending preliminary discussions with investment bankers. Her last meeting regarding the intended capital structure of Apix went well, and she calls you into her office to discuss the next steps.
“We will need to determine the required return for our intended project so that we have a decision criteria defined for the project,” she says.
“Do you have the information I need to describe capital structure and to calculate the weighted average cost of capital (WACC)?” you ask.
“I do,” she smiles. “We can determine the target WACC for Apix Printing Inc., given these assumptions,” she says as she hands you a piece of paper that says the following:
* Weights of 40% debt and 60% common equity (no preferred equity)
* A 35% tax rate
* Cost of debt is 8%
* Beta of the company is 1.5
* Risk-free rate is 2%
* Return on the market is 11%
“Great,” you say. “Thanks.”
“Be sure to indicate how these costs of capital might be used to determine the feasibility of the capital project,” Mary says. “I want your recommendation about which is more appropriate to apply to project evaluation, too. Let me know what you think.”
“One more thing,” she says as she stands up to signal the end of the meeting. “You did a good job with the explanations that you provided Luke the other day. Would you have time to define marginal cost of capital for me so I can include it in my discussions with investors? You seem to have a knack for making things accessible to nonfinancial folks.”
“No problem,” you say. “I’m glad my explanations are so useful!”
For this part, complete the following:
* Describe capital structure.
* Determine the WACC given the above assumptions.
* Indicate how these might be useful to determine the feasibility of the capital project.
* Recommend which is more appropriate to apply to project evaluation.
* Define marginal cost of capital.

Part 2

Over lunch, you and Mary meet to discuss next steps with the expansion project.
“Do we have everything we need on sales and costs?” you ask. “It must be time to compute the net present value (NPV) and internal rate of return (IRR) of the Apix expansion project.”
“We have the data from James and Luke regarding projected sales and costs, respectively, for the food packaging project,” says Mary. “It is feasible to project that we will receive a tax break from this implementation. I have information from our audit firm that indicates that future depreciation methods for taxes will be straight-line; however, the corporate rates will be reduced to 35% as we assumed in our weighted average cost of capital (WACC) calculation.”
“That sounds good,” you say.
“Right,” says Mary. “You can use a WACC of 10% for the computation of the NPV and comparison for IRR.”
“I’ve got the information I need from Luke and James,” you say. “Does this look right to you? Here’s what they gave me,” you say, as you hand a sheet of paper to Mary.
“Let’s look at this now while we’re together,” she says.
The information you hand to Mary shows the following:
* Initial investment outlay of $30 million, consisting of $25 million for equipment and $5 million for net working capital (NWC) (plastic substrate and ink inventory); NWC recoverable in terminal year
* Project and equipment life: 5 years
* Sales: $25 million per year for five years
* Assume gross margin of 60% (exclusive of depreciation)
* Depreciation: Straight-line for tax purposes
* Selling, general, and administrative expenses: 10% of sales
* Tax rate: 35%
You continue your conversation.
“It looks good,” says Mary. “Use this information from Luke and James to compute the cash flows for the project.”
“No problem,” you say.
“Then, compute NPV and IRR of the project using the Excel spreadsheet I sent earlier today,” says Mary. “Use the IRR financial function for the computation of IRR.”
“Okay,” you say. “I’ll submit my Excel file showing the computation of cash flows, NPV, and IRR by the end of week so you can look at it over the weekend.”
“Thanks,” says Mary.
Complete the above worksheet for part 2.