Introduction
You have recently been hired by Orange Corp. in the finance area. Orange is considering an expansion for its core business for year 2009 from two mutually exclusive projects. The projects being considered have similar risk characteristic to the company itself. Since the investment is part of company’s effort to expand its business, Orange plans to use retained earnings and issue new bonds to facilitate one of the two projects as well as other new business investment being evaluated by your Orange’s colleagues. Orange’s marginal tax rate is 35%.
The resulting capital structure is following:
Addition to Retained Earnings $80,000,000
New Issue Debt $90,000,000 (Market Value)
Stocks
Orange stock’s beta is 1.28. Currently, one-year T-bill rate is 1.5% and the S&P 500 index return is 5.5%. Additionally, starting from this year, Orange plans to pay dividends at a growing rate of 3%. Last week, the company paid dividend of $1.5 per share.
Bonds
Currently, Orange’s previously issued bonds are selling in the market for $975.65. The bonds will mature in 12 years, carry coupon rate of 8% and pay coupon annually. In order to pursue the investment, CFO of the company has negotiate with an investment bank and arrived at a conclusion that Orange can issue new 10-year bonds with face value of $1,000 pay annual coupon of 11% and can be sold in the market for $1,150. The investment bank will charge 6.0% fee on selling price. Orange will issue these bonds totaling $90,000,000.
CF of the projects
Project A
Machine A cost $95,000,000. This machine will increase earning before interest and taxes (EBIT) by $5,650,000 per year, on average, for the first 10 years. Starting from year 11, annual EBIT will increase at a very low growth rate of 1.5%. Assume that IRS allows this type of machine to be depreciated over 10 years. However, you know that this machine could last a really long time. Hence, you assume that Machine A will last forever. To operate the machine properly, workers have to go through a training session that would cost $600,000 Additionally, it would cost $800,000 to install this machine properly. Machine A will also require that Orange increase inventory of $2,000,000 to reach the most efficient machine capacity.
Project B
Machine B cost $75,000,000. This machine will increase earning before interest and taxes (EBIT) by $900,000 for the next year (first year after the installation). The EBIT generated from machine B will grow at 20 % per year from the beginning until the end of year 5. Then, EBIT will grow at 12% per year from the end of year 5 until the end of year 10. From year 11 onward, EBIT will grow at a much lower growth rate of 4.25%. You believe that machine B, similar to machine A, will last forever. To operate the machine properly, workers would have to go through a training session that would cost $380,000. Additionally, it would cost $320,000 to install this machine properly. Orange will not have to increase any inventory. Assume that IRS allows this type of machine to depreciate for 10 years.
Corporate Finance: Term Project 1 Instructor: Supasith Chonglerttham
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The assignment
Your boss requests that you analyze these two projects and make an investment recommendation. During a brief with him this morning, he asked you the following questions.
Questions
1. What is the required rate of return on Orange’s stock?
2. What should be Orange’s current stock price?
3. What is the yield to maturity on Orange’s outstanding bonds?
4. What would be the rate of return to investors from newly issued bonds?
5. Why are the [percentage] costs of currently outstanding debt and newly issued debt
different?
6. What would be the [percentage] cost to the company from newly issued bonds?
7. What should be an appropriate hurdle rate [require rate of return] to evaluate these two
new projects?
8. What project should Orange invest?
Evaluate projects: NPV; PI; and EAA
Note that each project has three different type of cash flow being evaluated
1) Initial Outlay
2) Annual free cash flow
3) Terminal cash flow and/or terminal value of all future cash flows
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