Felicia & Fred's executive board has asked you to change the decision model previously completed to reflect the following changes regarding increased leverage, WACC, and cash flows. It is your job to calculate the decision rules for NPV and IRR given the information provided.
Requirements:
1. Determine the new target weighted average cost of capital for Felicia & Fred, given following assumptions:
- Weights of 70% debt and 30% common equity (no preferred equity); this essentially reverses their previously calculated capital structure
- A 35% tax rate
- The cost of debt is now 10% due to an additional default risk premium
- The beta of the company is 1.3
- The risk free rate is 2%
- The return on the market is 12%
Use the CAPM for calculation of the cost of equity.
2. Calculate the cash flows for the new crystal jewelry project given the following assumptions:
- Initial investment outlay of $25 million, comprised of $20 million for machinery with $2 million for net working capital for metal inventory and $3 million for crystals
- Project and equipment life is 5 years
- Revenues are expected to increase $12 million annually
- Gross margin percentage is 40% (not including depreciation)
- Depreciation is computed at the straight-line rate for tax purposes
- Selling, general, and administrative expenses are 5% of sales
- Tax rate is 35%
Compute net present value and internal rate of return of the project.