Delaney Pumps manufactures and distributes an extensive line of agricultural irrigation sys- tems. In recent years,...

 

 

  


 


 

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Delaney Pumps manufactures and distributes an extensive line of agricultural irrigation sys- tems. In recent years, computerized control systems used to automate irrigation and to conserve water have become increasingly important in selling high-end systems. Delaney management, is thus considering investing $160 million to develop a state-of-the-art, computerized controller that promises to leapfrog competition. Development work would be contracted to a software development company on a cost-plus basis. Revenue would come from a new product line fea- turing the controller and from license fees from selected competitors who elected to include the controller in their products. Projected cash-flows for the investment are given in the following table: Year 0 1 2 3 4 EBIT $50.0 $150.0 $80.0 $30.0 Expected FCF $(160.0) 30.0 120.0 60.0 70.0 The projections extend for only 4 years because management anticipates that other, more advanced controllers will be available by this time. Two challenges confronted Delaney's management as they began their deliberations. 1. Because the digital controller appeared much riskier than the company's usual capital expenditures, managers chose to use a hurdle rate which was higher than the usual 10%. The treasurer reasoned that the digital controller would be an average risk project for software companies, and identified five smaller, publicly traded firms specializing in busi- ness automation software. By unlevering their equity betas, she estimated the industry. asset beta to be 3A = 2.41. 2. Delaney had traditionally financed its business with the goal of maintaining a target times- interest-earned ratio of 3 to 1 (times-interest-earned ratio = EBIT/Interest Expenditure). But since this project consisted almost entirely of intangible computer code and because its cash flows were quite uncertain, Delaney's treasurer thought it prudent to target a higher interest coverage of 10 to 1. Delaney's treasurer chooses to evaluate the project using the APV method. Given the above information: (a) Compute the unlevered cost of capital for Delaney's project, knowing that the risk-free rate of interest is 4.2% and that the market risk premium is 6.4%. Use ry to discount the free cash flows in the above table, and compute the project NPV assuming all-equity financing. (b) Given a times-interest-earned target ratio on this project of 10 to 1, the annual interest on which the project can claim tax shields is 1/10 of its EBIT for the next 4 years. Assume a 40% corporate tax rate and compute the interest tax shields implied by the project. (c) Answer the following two questions: Continued on next pag (i) The present value of tax shields should reflect the risk of the cash flows that are being discounted. Given that in this case their amount is tied mechanically to operating income, they share the risk of the project. What is the appropriate discount rate for the tax shield? Which rate would have been more appropriate if Delaney had chosen. to fix the amount of debt independently of the projected EBIT? (ii) Should Delaney invest in the project? Delaney Pumps manufactures and distributes an extensive line of agricultural irrigation sys- tems. In recent years, computerized control systems used to automate irrigation and to conserve water have become increasingly important in selling high-end systems. Delaney management, is thus considering investing $160 million to develop a state-of-the-art, computerized controller that promises to leapfrog competition. Development work would be contracted to a software development company on a cost-plus basis. Revenue would come from a new product line fea- turing the controller and from license fees from selected competitors who elected to include the controller in their products. Projected cash-flows for the investment are given in the following table: Year 0 1 2 3 4 EBIT $50.0 $150.0 $80.0 $30.0 Expected FCF $(160.0) 30.0 120.0 60.0 70.0 The projections extend for only 4 years because management anticipates that other, more advanced controllers will be available by this time. Two challenges confronted Delaney's management as they began their deliberations. 1. Because the digital controller appeared much riskier than the company's usual capital expenditures, managers chose to use a hurdle rate which was higher than the usual 10%. The treasurer reasoned that the digital controller would be an average risk project for software companies, and identified five smaller, publicly traded firms specializing in busi- ness automation software. By unlevering their equity betas, she estimated the industry. asset beta to be 3A = 2.41. 2. Delaney had traditionally financed its business with the goal of maintaining a target times- interest-earned ratio of 3 to 1 (times-interest-earned ratio = EBIT/Interest Expenditure). But since this project consisted almost entirely of intangible computer code and because its cash flows were quite uncertain, Delaney's treasurer thought it prudent to target a higher interest coverage of 10 to 1. Delaney's treasurer chooses to evaluate the project using the APV method. Given the above information: (a) Compute the unlevered cost of capital for Delaney's project, knowing that the risk-free rate of interest is 4.2% and that the market risk premium is 6.4%. Use ry to discount the free cash flows in the above table, and compute the project NPV assuming all-equity financing. (b) Given a times-interest-earned target ratio on this project of 10 to 1, the annual interest on which the project can claim tax shields is 1/10 of its EBIT for the next 4 years. Assume a 40% corporate tax rate and compute the interest tax shields implied by the project. (c) Answer the following two questions: Continued on next pag (i) The present value of tax shields should reflect the risk of the cash flows that are being discounted. Given that in this case their amount is tied mechanically to operating income, they share the risk of the project. What is the appropriate discount rate for the tax shield? Which rate would have been more appropriate if Delaney had chosen. to fix the amount of debt independently of the projected EBIT? (ii) Should Delaney invest in the project?

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