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The Apix Printing Inc. board of directors has recently completed its multiyear strategic plan. The chief executive officer (CEO), John Matthews, and the vice president (VP) of sales and administration, James Simeon, meet with you and Mary Francis to discuss it. Included in the plan is an intent to diversify Apix’s current product line to include food packaging. Additional investment is required for this expansion, and equipment and inventory will need to be procured and placed in service.
As the VP of Finance, you will soon need certain information for computing the net present value (NPV) and the internal rate of return (IRR) for Apix’s expansion project. The calculations will be presented to the board at the next quarterly meeting for approval. Today, you are meeting with CEO John Matthews and Luke Stewart, VP of production and supply chain to discuss the information.
Luke is excited about the prospect of going into another line of business, and he says, “I know our employees will be eager to learn new processes if it means long-term job security and profitability for the company.”
“Everyone will benefit if we are able to implement the project,” says John. “So, to gather enough capital, we must present an appealing prospectus to shareholders and bondholders. Naturally, investors want some assurance that their investment will yield returns; and it’s up to us to properly assess our project given the cost of capital.”
You nod in agreement and say, “We need everyone in the organization to have an appreciation for these calculations and the information that goes into them. These estimates are important because the board’s approval will allow the company to diversify into the food packaging business.”
Luke holds out both hands and says, “You know, my understanding is somewhat basic on the two theoretical approaches you’ve talked about. Let’s go over some of the basics now so my grasp of the financial end of this is clearer.”
“Good idea, Luke,” you say. “I’ll prepare brief definitions of the project financial valuation methodologies NPV and IRR.”
You also need to explain the following to Luke:
- How the application of weighted average cost of capital (WACC) would be applied to each method
- How companies assess the feasibility of a project according to these valuation methodologies
“That would be a big help,” says Luke. “Thanks.”
“Once you get my explanations, you’ll be able to explain it to others,” you say.
Mary Francis has just returned to her office after attending preliminary discussions with investment bankers. Her last meeting regarding the intended capital structure of Apix went well, and she calls you into her office to discuss the next steps.
“We will need to determine the required return for our intended project so that we have a decision criteria defined for the project,” she says.
“Do you have the information I need to describe capital structure and to calculate the weighted average cost of capital (WACC)?” you ask.
“I do,” she smiles. “We can determine the target WACC for Apix Printing Inc., given these assumptions,” she says as she hands you a piece of paper that says the following:
- Weights of 40% debt and 60% common equity (no preferred equity)
- A 35% tax rate
- Cost of debt is 8%
- Beta of the company is 1.5
- Risk-free rate is 2%
- Return on the market is 11%
“Great,” you say. “Thanks.”
“Be sure to indicate how these costs of capital might be used to determine the feasibility of the capital project,” Mary says. “I want your recommendation about which is more appropriate to apply to project evaluation, too. Let me know what you think.”
“One more thing,” she says as she stands up to signal the end of the meeting. “You did a good job with the explanations that you provided Luke the other day. Would you have time to define marginal cost of capital for me so I can include it in my discussions with investors? You seem to have a knack for making things accessible to nonfinancial folks.”
“No problem,” you say. “I’m glad my explanations are so useful!”
For this assignment, complete the following:
- Describe capital structure.
- Determine the WACC given the above assumptions.
- Indicate how these might be useful to determine the feasibility of the capital project.
- Recommend which is more appropriate to apply to project evaluation.
- Define marginal cost of capital.