Reference no: EM132466449
You are working for a firm that currently manufactures stainless steel pipes. A marketing person has come up with an idea to take a portion of the output of steel pipes and slice them into thin bands which can then be polished and sold as high-end bracelets (jewelry). Since it is made of stainless steel, it is not going to cause allergies, and will also not tarnish or fade; consequently, the product-related risk is very minimal. The demand for such bracelets will be very high as your firm will hire Lady Gaga as the celebrity who will endorse the product. You have been assigned to analyze whether to invest in this new product. You have gathered the following data:
a. Initial investment for product design, equipment purchase, marketing set-up including endorsement contract payment to Lady Gaga, etc: $20,000,000 cash outflow
b. Estimates of project free cash flow on an after-tax basis are provided below:
Year 1 $9,500,000 Year 2 $15,000,000 3 Year$12,000,000 Year 4 $10,000,000 Year 5 $8,000,000 (after tax free cash inflows )
c. Following the fifth year, after-tax cash inflows are expected to grow forever at a 2% growth rate per year.
d. Since your firm makes steel pipes, the entry into the jewelry business can be viewed as entering a totally different industry. Consequently, you realize that it is inappropriate to use your current cost of capital since that applies to a steel industry pipe manufacturing firm; not a jewelry manufacturer. Fortunately, you remember the concept of the pure-play method for which you know the Hamada model can be used. To implement this method, you have other data as shown below:
e. You have identified a jewelry manufacturer, Trinket Corp (Ticker: TCKT) which is publicly traded, and you have obtained its data, which are provided below:
Beta of TCKT = 2.0
Debt to Equity ratio of TCKT = 1.2
Tax rate of TCKT = 40%
In discussions with your CFO, she has told you that your firm intends to finance the investment into the jewelry business with a capital structure where the debt to equity ratio will be 2.0 (i.e., 2 parts debt to 1 part equity). Furthermore, your firm's tax rate is expected to be 40% for the foreseeable future. She also told you that the all-in pre-tax rate at which your firm can borrow debt is 8% per year. Further, for inputs into the Capital Asset Pricing Model, you can assume that the risk free rate is 4% per year, and the Market Risk Premium is 5% per year. Given the above data, please answer the following:
- What is the beta unlevered for the jewelry business assuming that TCKT is very representative of this whole industry?
- What is the beta that your firm will have for its venture into the jewelry business?
- What will be your firm's cost of equity in the jewelry business?
- What is your firm's after tax cost of capital?
- What is the NPV of the jewelry project?