PLEASURE CRAFT INC. Case Solution
Therefore, the company’s current cost of capital would not reflect this risk. In order to calculate the weighted average cost of capital for this project, first of all the beta asset has been computed for comparable companies shown in Exhibit 3a of the case. These companies have been used because they produced the same product and thus their risk would be similar for this business segment.
Risk free rate has been provided which is 6%, return on market has been calculated by averaging the market returns from exhibit 2 for period 1973 to 2000. The cost of equity using CAPM is 16.48% including floatation costs of new equity issue. The cost of debt has been assumed to be equal to the recent 10-year bond issue of the company at coupon rate of 8%. The financial calculator has been used to compute its yield to maturity which has been used as the cost of debt for PC. The cost of debt after tax is 4.73%. Using these inputs, the cost of capital for PC is 13.23%.
Net Present Value & IRR
Using the net cash flows and the cost of capital of 13.23%, the net present value for the front end loader project has been computed which is $ 133.32 million. The internal rate of return for this project has also been computed using the initial gross investment of $ 18.18 million. The IRR for this project is 86% which is quite a huge return.
Outboard Motor Project
This is the second investment option for PC Company. This project would allow the company to remain within the leisure craft market and also utilize its existing selling network.
Annual Cash Flows
The annual cash flows have been computed for the 20 year life of this project with gross investments in year 0 and salvage value realization in last year. There would be no cash flows associated with the sales team development as the sales team already exists however, sales commission would still be paid to the sales people. The calculations for the net cash flows for this project could be seen in the excel spread sheet.
Weighted Average Cost of Capital
The risk for this project would be equal to the current level of the risk of the company therefore, using the current beta of PC of 1.38 and all the other inputs for front end loader project the cost of capital for this project would be 12.89%.
Net Present Value & IRR
Using the above calculated annual cash flows and the cost of capital of 12.89%, the net present value for the Outboard Motor project is $ 11.99 million with an IRR of 21%. These values are quite low as compared to the values for Front end loader project however, still they are positive.
Evaluation of Financing Options
In order to undertake both the above projects or any one project, the management of the company would require extensive financing to fund these projects. Traditionally, the management of the company has been relying on its internally generated funds and the debt of the company to fund its projects.
Most of the times, the management had to delay certain profitable and lucrative projects because of the lack of internally generated funds. However, since the current projects which are being considered by PC company are larger in scope and size therefore, the management of PC expects to raise around $ 20 million in new equity for these project. The three main financing options for the company are as follows:……………..
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