You are making four-year cash flow projections for a restaurant chain. Analysts estimate that the typical cost of debt for the industry is approximately 6%. The projected equity beta for the project is 2, and the firm is planning to maintain a constant debt-to-equity ratio (in market values) of 0.5. Expert forecasts predict that the annual expected return for the entire market will be 10%, and that the risk-free rate will remain at 4% over the entire life of the project. Assume a marginal tax rate of 25%.
Firm revenues are expected to be $8 million at the end of the first year and are expected to grow at a rate of 10% per year. Labour is expected to cost approximately 10% of revenues every year, while COGS are estimated to be 40% of revenues each year.
The equipment needed costs $10 million, and according to the tax authority, is depreciated using the straight-line method. You will operate the machinery for four years. The salvage value of the machinery at the end of the four years is expected to be $3 million. The purchase of the machinery is made today.
You also expect to incur additional capital expenditures of $2 million for new equipment at the end of year 2. This equipment is depreciated using the straight-line method over the remaining life of the project and is not expected to have any salvage value.
The net working capital required for the project is given by the following data: days sales outstanding will be 30 days (out of a 360-day cycle) and based entirely on annual revenues, while days payable outstanding will be 30 days (out of a 360-day cycle), and will only be relevant for labour costs (not for COGS or any other expenses). Inventory will be 10% of COGS each year. Assume net working capital is 0 as of today, and fully recovered by the end of the project.

a) What is the weighted average cost of capital for the project?

b) Please forecast the free cash flows for the project (use 4% as the risk-free rate).

c) What is the NPV of the project?

d) The assumptions, how far can COGS rise (as a percentage of revenues) before the project NPV becomes negative?

Answer rating: 100% (QA)

a To calculate the weighted average cost of capital WACC we need to first calculate the cost of equity and the cost of debt The cost of debt is given as 6 The cost of equity can be calculated using th... View the full answer