The Frank Stone Company is considering the introduction of a new product. Generally, the company’s products have a life of about 5 years, after which they are deleted from the range of products that the company sells. The new product requires the purchase of new equipment costing $4,000,000, including freight and installation charges. The useful life of the equipment is 5 years, with an estimated resale of equipment of $1,575,000 at the end of that period. The equipment will be fully depreciation to zero value using the straight line (prime cost) method.
The new product will be manufactured in a factory already owned by the company. This factory is currently being rented to another company under a lease agreement that has 5 years to run and provides for an annual rental of $150,000. Under the lease agreement, the Frank Stone Company can cancel the lease by immediately (year 0) paying the lessee compensation equal to 1 year’s rental payment.
It is expected that the product will involve the company in sales promotion expenditures that will amount to $500,000 during the first year the product is on the market. Additions to current assets (net working capital) will require $225,000 at the commencement of the project and are assumed to be fully recoverable at the end of the fifth year.
The new product is expected to generate sales revenue as follows:
Year 1: $3,000,000
Year 2: $3,500,000
Year 3: $3,250,000
Year 4: $3,000,000
Year 5: $1,500,000
It is assumed that all cash flows are received at the end of each year. The corporate tax rate is 35%.
Frank Stone Company has an equity beta of 0.5. Its capital structure consists of equal amounts of equity and debt. The risk free rate is 6%. The debt has a pre-tax yield of 10% and the expected rate of return on the market index is 18%.
Using the inputs suggested in the proposed investment, design an Excel financial model that can help to evaluate the project. The model should enable Frank Stone Company to consider the project and forecast the net cash flows. 5 marks will be allocated for the presentation and clarity of your model (e.g., if there are clear headings, clear arrangement for input cells, appropriate use of colors, have some degree of flexibility, generate warning messages for wrong user inputs, etc.).
Answer the following questions using your Excel financial model:
a. (5 marks)
What is Frank Stone Company â€™s weighted average cost of capital (WACC)?
b. (15 marks)
Estimate the free cash flows of the project.
c. (7 marks)
What is the net present value (NPV) and internal rate of return (IRR) of the project? Should Frank Stone Company undertake the project based on NPV? How about IRR? Do both NPV and IRR lead to the same decision?
d. (8 marks)
Draw a line graph to explain the sensitivity of the NPV to changes in WACC? The graph should have a chart title, as well as x- and y-axis labels.