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1. Catola Shoes, an athletic shoe and clothing manufacturer, is considering a move into the fashion clothing business, making high-priced casual clothing for the teenage and young adult markets. The beta for Catala is 0.90, calculated using monthly returns over the last 5 years and against the S&P 500 Index. You have estimated the unlevered beta for fashion apparel companies to be 1.15. The current stock price for the firm is $55 and there are 700 million shares outstanding. Catola expects to finance this apparel division using the same mix of debt and equity(in market value terms) as it is using currently in the rest of its business. Catola has debt outstanding with a book value of $2 billion and an average time to maturity of 5 years. The company's interest expense last year was $150 million. Catola's debt is currently rated A+, and A+ rated bonds trade at a default spread of 1.0% over the long-term treasury bond rate. The 10-year U.S. Treasury bond currently yields 3% and the market risk premium is 6%.Catola pays a marginal tax rate of 40%.
What cost of capital should Catola use in evaluating this project?
2. Catola estimate that it will cost $3 billion to get started in this business. This investment will be depreciated on a straight-line basis over the next ten years. Revenues are expected to be $2 billion per year and production expenses (Cost OfGoods Sold, etc.) will be 75% of revenues. In addition, Catola will allocate $100 million G&A expenses to the project each year. (The actual increase in G&A costs due to this project will be $50 million.) The project will require net working capital of 7% of revenues. This working capital investment will be required at the beginning of the project. All assets associated with the project will be sold for book value when the project is terminated in ten years. Catola pays a marginal tax rate of 40%. What is the NPV of the project and should Catola go ahead with it?
3. After you complete the analysis in problem 2, Catola announces that they do not plan on shutting down the project in ten years. Instead they think the clothing line will last indefinitely (assume forever). They also announce that their distribution network, which was operating at 60% capacity without the project and would not have to be upgraded until year 11, will now have to be upgraded in year 6 if they take the project. The total cost of the upgrade (including the PV of depreciation tax shields) is $1 billion no matter when they do it. You are also told that all of the cash flow estimates were based on a research study that Catola had done at a cost of $200 million. Assuming that costs and revenues remain constant what is your new estimate of the NPV of this project?
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