Sterling Household Products Company Case Solution
Correct Capital Structure and WACC
The management of the company is considering achieving a targeted capital structure, which is 30% debt and 70% equity, therefore it is expected that targeted capital structure is the correct capital structure for the evaluation of the proposed investment plan. The calculation of the cost of equity and cost of capital is also based upon this targeted capital structure.
It is expected that currently the company has 20% debt in its capital structure. As the company is going to raise finance through debt in order to finance the proposed expansion plan, therefore raising funds through debt will affect the current capital structure of the company and it is expected that it will change the capital structure to 30% debt and 70% equity ratio. The cost of capital for the proposed expansion plan is 6.63%, which is based upon the targeted capital structure.
It is expected that the cost of capital changes continuously throughout the life of the project as it based upon the market returns, market premiums and beta factor which also changes continuously however, for simplicity it is expected that WACC will remain same through the life of the project, which is the limitation of the WACC but taking different WACC for different periods could make the calculation more complex.
Free Cash Flows of Base Case Acquisition Opportunity till 2022
In order to analyze the acquisition opportunity till the year 2022 with respect to the base case investment appraisal, the free cash flow method is used. It is expected thatthe free cash flow is the appropriate method for the evaluation of the proposed expansion plan as it would providecash flows in real terms.
The free cash flows are calculated by adding back depreciation in to the profit after tax, deducting capital expenditure and adjusting working capital changes. However, before performing the free cash flows methodology, forecasting is performed on the basis of average growth rates. By taking the operating profit figure of the year 2017 and adding average growth of last two years operating profit for the year 2018 are identified. Similar practice is performed for the projected years.
The average growth model is also used in order to identify working capital changes and it is expected that the capital expenditure will remain same for the next projected years. By incorporating all these values and 35% tax rate, the free cash flows for the next 10 years are calculated. Moreover, in order to realize future gains, the terminal value is also calculated for the next years and for that purpose the free cash flows of the year 2022 are used.
Terminal value of 2022
In order to calculate terminal value of the project, the last years’ free cash flows are used and multiplying the free cash flows of the years 2022 with 9 terminal values is identified, which is $215731 million. In order to identify the present value of the terminal value, it is also discounted at WACC.
Net Present Value of Base Case Free Cash Flows
By incorporating all free cash flows and applying a discount factor of 6.63%, the net present value of the base case is identified. Moreover, it is expected that under base case assumptions, the project is generating negative net present value as the project requires $265 million as an initial investment and it is generating 264.8 million dollars, hence under base case the project is generating low net present value with respect to the initial investment…………..
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