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 9% 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 to $25 million in each year 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.
3. Although crystal jewelry is extremely popular at the moment, Felicia & Fred are concerned about the product life cycle and would like to explore an abandonment option. Management asks for an additional scenario to be developed, reflecting a three- rather than a five-year life cycle for this project, including cash flows and asset life. Compute the net present value and internal rate of return given this change in parameter.
You may use Excel to complete this project. The text has a number of resources that provide examples of spreadsheet solutions for this purpose. Model your responses according to these examples.
Additionally, provide a 250-500 word executive summary on the results of the decision rule given these two scenarios with a five- and three-year project life, and revised WACC. Advise Felicia & Fred specifically regarding the abandonment option versus the initial five year project.