Estimate the appropriate Weighted Average Cost of Capital
Estimate the appropriate Weighted Average Cost of Capital. Neways Tractor Corporation owns and operates a transmission and axle plant. The company manufactures more than half of the transmissions and axles used in tractors and harvesting equipment servicing Australia’s agricultural industry. Extensive machining is performed on steel parts for the final assembly of transmissions and axles, so a very large amount of steel shavings and bulky steel scrap is generated at this plant. The unprocessed
steep scrap is sold as a by-product of the manufacturing operation to various firms involved in the recycling process.
The executive committee wants to evaluate whether to process the scrap into different grades and types of usable steel. Using different models of chip crushers, the scrap can be grinded and compressed into either rough or fine scrap. Neways has to decide whether to invest in the high-cost chip crusher (HCC) to produce fine scrap, or the low-cost chip crusher (LCC) to produce rough scrap.
You have gathered the relevant purchase prices and operating costs of the two chip crushes from the supplier ,along with information on marketing and staff costs. Key estimates of financial data (before-tax) for the two
machines are summarised below:
LCC HCC
Machine cost $400,000 $480,000
Life (years) 4 6 Depreciation Straight-line over 4 years Straight-line over 6 years
Salvage value – end of useful life $80,000 $48,000
Annual interest expense on loan $48,000 $48,000
Annual revenue from scrap sales $450,000 $500,000
Annual operating costs:
– Variable costs $50,000 $150,000
– Salaries $80,000 $110,000
– Marketing $45,000 $60,000
The calculation for annual operating costs comprise of the following items:
– Variable costs are direct operating expenses incurred in the production of the rough or fine scrap.
– Salaries for the LCC machine comprise of employing two new operators at a salary of $40,000 per annum each.
– For the HCC machine, the company will only need to employ one new machine operator with a salary of
$40,000 per annum. The second operator who earns $70,000 per annum will be transferred to this division from the axle assembly plant.
– Marketing costs are paid at the start of each year.
Neways is a private company, soundly financed and consistently profitable. Cash on hand is not sufficient to buy the chip crusher. However Mr Jack Murray the CEO, is confident that the cost of the chip crusher could be financed with medium-term debt. The company currently has an existing mortgage with $1 million outstanding. This is financed at a rate of 10% per annum. If the firm chooses either machine, it will arrange to borrow
$400,000 at a fixed rate of 12% per annum, payable over 4 years. The firm’s has $3 million worth of issued shares, and investors expected to earn a 19% per annum rate of return. Should the firm choose to proceed with either machine and the firm commits to the new loan, this is expected to impact the company’s average cost of capital.
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The company’s accountant Mr Peter Smith, pointed out to you that the revenue figures do not take into consideration the impact of this project on current sales of unprocessed scrap. The current unprocessed scrap generates a before-tax net income of $50,000 per year.
Production for the rough or fine scrap would be set up in an unused section of Neway’s main plant. This section has been unused for years and consequently had suffered some deterioration. Last year as part of a routine facility improvement program, Neways spent $75,000 to rehabilitate the very same section of the plant. Mr Smith believes this outlay which has already been paid and expensed for tax purposes in last year’s income statement, should be charged to this steel scrap project. He argues that if the rehabilitation had not taken place, the firm would have to spend the money to repurpose the site for the steel scrap project anyway.
Mr Murray wants to see some type of risk analysis on the project as it may look profitable, but he worries that there is a chance it might turn out to be a loser. You met with the marketing and production managers to get a feel for the uncertainties which may impact the cash flow estimates. After several rounds of discussions, they conclude that revenue at the end of the first year could vary by 25%, and variable costs by 35% from the initial
projections.
After reviewing the data provided, you realise that the revenue and cost figures have not been adjusted for inflation which is expected to average 5% per year over the next 4 to 6 years. Inflation impacts the firm’s revenues and costs at varying degrees. For both chip crushers, the sales revenues are expected to increase by 5% per year after Year 1. However, variable costs, salaries and marketing costs are expected to increase by only
3% p.a. after Year 1, because half of the costs are fixed by long-term contracts.
Your task is to prepare an investment recommendation in the form of an executive summary to Mr Murray and the executive committee of Neways Tractor Corporation, indicating whether the firm should invest in the LCC or the HCC. Your recommendation should address the issues from Questions 1 to 8. Your executive summary should start by outlining your recommendation. You should also discuss the assumptions you have made, and justify your choice based on sound investment selection criterions. The committee would also like to be informed on key areas of concern impacting the feasibility of the project. Your workings and calculations must be attached at the back of your recommendation as supporting material.
Address the following when putting together your analyses and Executive Summary.
1. Estimate the appropriate Weighted Average Cost of Capital (WACC) applicable as the project’s required rate
of return.
2. Discuss if the following should or should not be included in your incremental cash flow calculations:
The yearly interest expense on the $400,000 loan.
Salaries of the machine operators.
The $75,000 spent to rehabilitate the plant.
Unprocessed scrap income of $50,000 per year.
3. Prepare the incremental cash flow tables for the 4-year LCC and the 6-year HCC. Assume these are the base case scenarios for each.
4. Which machine is recommended based on the Net Present Value, Internal Rate of Return, Profitability Index, and Payback Period criterions?
5. How would your recommendation change when the difference in project lifespans are taken into consideration?
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6. Rework your analyses from Questions 3, 4 and 5 for both machines, taking into consideration the possible variations in revenue and variable costs estimates at the end of Year 1. Report the results of your sensitivity analysis and discuss how this will impact the choice between LCC and HCC.
7. Determine the minimum level of revenues and maximum level of variable costs in order to breakeven, for the machine recommended in Question 6.
Answer preview: Estimate the appropriate Weighted Average Cost of Capital
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