Reference no: EM133369143
Case Study: Stevens Healthcare Corp., an upstart Canadian technology firm, is contemplating the purchase of electronic communications equipment at a cost of $30 million to add to the existing pool of similar equipment. They expect that this equipment will have a useful life of 8 years, at which point they estimate its salvage value to be $3 million.
The new equipment will generate sales of 60,000 units this year, which are expected to increase by 9% per year for the next 3 years, after which the growth rate will decrease by 1% per year for the remainder of the life of the project. The price per unit is going to be $100 this year, increasing at a projected rate of 3% per year, and the variable costs are estimated to be at 50% of the sales price. Fixed costs are $0.75 million this year; they are also expected to increase by 3% per year.
It is also expected that the new purchase will require an immediate increase in inventories of $1 million, an immediate increase in accounts receivable of $0.75 million, and an immediate increase in accounts payable of $1 million. Subsequently, total net working capital at the end of each year will be 10% of the dollar value of sales for that year. The net working capital amounts will be recaptured at project termination.
It is expected that Stevens Healthcare will finance this purchase with 60% debt and the remainder with equity. As it presently has no debt, it is expecting to offer debt for the duration of the project with a coupon of 3%, and it is projected to sell for 99% of face value. Flotation costs on debt (i.e., costs of issuing debt) are expected to be 2%. It is expected that the additional equity amount will have a systematic risk component based on its exposure to the S&P/TSX index, and that the risk-free rate is expected to be the 3-month T-bill rate, presently at 2% annual. Monthly prices on Stevens Healthcare and the S&P/TSX index are on provided on Brightspace in a spreadsheet titled "Final Project Data". Flotation costs on equity are expected to be 3%. Stevens Healthcare's historical earnings are shown in the table below.
|
Year
|
2017
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2018
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2019
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2020
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2021
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2022
|
|
Earnings, mln. $
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1.2
|
1.5
|
1.6
|
1.8
|
1.6
|
1.9
|
Currently, Stevens Healthcare has 2 million shares of stock outstanding. It has a tradition of paying 50% of its earnings as dividends. Stevens Healthcare falls into the 30% corporate tax bracket and cannot carry losses forward.
Questions:
1. What are the cash flows to assets from the project in years 1-8?
2. What is Stevens Healthcare's cost of capital (WACC) for this project?
3. Explain (no more than one page) whether Stevens Healthcare should proceed with this project. Support your conclusions with all relevant investment criteria (i.e., NPV, IRR, payback etc.) you can calculate given the information contained herein.