- Length: 13 pages
- Subject: Business
- Type: Case Study
- Paper: #60364966
- Related Topic: Debt Financing, Costco, Capital Budgeting

14949.4

16860

18861.8

19394.5

19933.7

20479

20882.2

Looking at these figures, we can see immediately that the most important assumption Gates has made with respect to free cash flow is that the project will go beyond the initial three years contract. The nominal value of the cash flows associated with those first three years does not equal the initial outlay. Thus, for the project to be profitable, the company must take it well beyond the three-year time horizon.

Weighted Average Cost of Capital

A typical metric that is used in capital budgeting decisions to determine the discount rate is the firm's weighted average cost of capital. There are a number of faults with using the WACC, however. Most of these faults relate to the fact that the WACC is based on current figures. This expansion is a major expansion of the firm therefore the cost of capital is impacted by two things that will change significantly if the firm undertakes this project. Hansson plans to use debt as the primary means of financing this expansion, and this will dramatically alter the firm's capital structure. This in turn should change the discount rate for the future cash flows, as the company's cost of capital is directly related to its firm-specific risk. The firm-specific risk for Hansson with an extra $50 million of debt on its books, and dependence on a single major customer, is going to be substantially higher than it would be under the current structure of the business. The estimates by the bank of the firm's cost of debt are dependent on the company maintaining its debt to value ratio within a specific bound, but the current WACC estimates are not going to reflect accurately the cost of debt should the firm move outside that bound, which is entirely possible with this project.

Another pitfall with using the WACC as the means of determining the discount rate is that the WACC is based on a set of assumptions. In addition to the assumption about the cost of debt being subject to the firm keeping its degree of leverage within specific, potentially unattainable parameters, the cost of equity is also subject to a set of assumptions. If Hansson was a publicly traded firm, the cost of equity could be estimated using CAPM and the firm's beta. However, because Hansson is a privately-held firm, the cost of equity must be estimated. The assumptions that are built into that estimation are critical to deriving an accurate WACC, but the fact that such assumptions need to be made weakens the value of the WACC as a tool to derive the discount rate.

With this in mind, the first step in determining the WACC needs to be to estimate a cost of debt and a cost of equity. The cost of debt has been established as 7.75% if the firm is able to keep its debt/value ratio below 25%. Hansson has a net debt level of $49.8 million at present, giving it a D/V of 9.7%; the new level post-expansion would be $107.6 million in debt for a D/V of 20.9%. It is reasonable to assume, therefore, that the cost of debt to be used in the WACC calculation is 7.75%. That the company has paid down a substantial portion of its 2003 debt level over the past several years means that it is able to take on this debt within exceeding the 25% threshold. The project is estimated to deliver positive cash flows in its first year, so there is no need to consider future, higher debt levels. More likely, the initial round of debt financing will be the peak of the firm's debt. The firm value level is also not expected to change significantly -- if anything the retained earnings will increase firm value. Thus, the 7.75% level for debt is reasonable.

For a private firm to estimate its cost of equity, the firm must select a comparable firm in the industry and use their figures to make this estimate. The estimate would then be used in the capital asset pricing model. The firm that should be used is the one that has the closest structure, risk level and size to the subject firm. The current enterprise value of Hansson is 7x last year's EBITDA. This figure is (7)*(73.5) = $514.5 million. The debt/equity ratio of Hansson at present is 20.4% using long-term debt as the figure; with the new project this figure will increase to 40.1%. The competitor with the closest enterprise value is Women's Care Company, and this company has a similar debt level at present to Hansson. Its revenues are much lower, and some of its other figures are also significantly better. WCC has a lower level of leverage as well. Another decent comparable is General Health & Beauty. GHB has a similar EBITDA, smaller net income, a similar debt level, a smaller enterprise value but a more similar D/E ratio. The betas of these two companies differ significantly. Hansson is subject to strong steady growth, which would imply a lower level of risk, but the company is set to increase its leverage and is also going to increase its dependence on a single customer. Thus, its risk profile, while currently being closer to that of WCC, is going to move towards that of GHB. As a result, it is reasonable to assume a beta in between the two comparable companies. The mean of the betas for WCC and GHB is (1.14+1.95)/2 = 1.545. Using this reasonable beta estimate for post-investment Hansson, the capital asset pricing model can be used to derive a cost of equity for the company:

Ra = Rf + B (Rf-Rm)

Ra = 3.75 + 1.545(5) = 11.475%

This can then be used to determine the weighted average cost of capital for this project:

WACC = (.604)(11.475) + (.396)(7.75) = 10%

Net Present Value

With a discount rate, the future cash flows can be discounted back. The NPV calculation is best conducted on Excel, but is based on the sum of the present value of each future cash flow. The PV of each future cash flow is calculated as follows:

PV = CF / (1+d)^t where CF = the future flow; d = discount rate and t = the year in which the flow is recorded. This delivers a net present value of:

Hansson Private Label

discount rate

0.1

Year

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

Year

0

1

2

3

4

5

6

7

8

9

10

Initial Cost

-50000

Revenue

0

84960

93881

103124

112700

122618

132887

135545

138256

141021

143681

Raw Materials

0

-45120

-49400

-53760

-58200

-62720

-67320

-68000

-68680

-69360

-70040

Mfg Overhead

0

-3600

-3708

-3819.24

-3933.82

-4051.8

-4173.39

-4298.6

-4427.5

-4560.4

-4697.2

Maintenance

0

-2250

-2317.5

-2387.03

-2458.64

-2532.4

-2608.37

-2686.6

-2767.2

-2850.2

-2935.7

Management

0

-160

-165.6

-171.396

-177.395

-183.6

-190.03

-196.68

-203.56

-210.69

-218.06

Hourly Labor

0

-18000

-19570.9

-21814

-24190.2

-26706

-29368.2

-30396

-31460

-32561

-33701

SGA

0

-6626.9

-7322.72

-8043.67

-8790.6

-9564.2

-10365.2

-10573

-10784

-11000

-11207

Free Cash Flow

-50000

11396.3

13128.7

14949.4

16860

18861.8

19394.5

19933.7

20479

20882.2

PV

-50000

10210.6

10468.7

10647

NPV

44962.72

The project has a positive net present value based on the cash flows estimates and discount rate. Therefore, it is recommended that Hansson undertake the project. It is worth noting, however, that payback for the project does not occur until 2014, which is six years out. The NPV for this project for the three-year run of the contract is as follows:

Hansson Private Label

discount rate

0.1

Year

2008

2009

2010

2011

Year

0

1

2

3

Initial Cost

-50000

Revenue

0

84960

93881

103124

Raw Materials

0

-45120

-49400

-53760

Mfg Overhead

0

-3600

-3708

-3819.24

Maintenance

0

-2250

-2317.5

-2387.03

Management

0

-160

-165.6

-171.396

Hourly Labor

0

-18000

-19570.9

-21814

SGA

0

-6626.9

-7322.72

-8043.67

Free Cash Flow

-50000

11396.3

13128.7

PV

-50000

NPV

-22351.4

The project has a significantly negative net present value for the first three years. Hansson must therefore ensure that it is able to extend the contract beyond the initial three years. Failure to do so will put the project strongly into the black and will jeopardize the future of the company.

However, if the project can be extended out to 2018, then the project will have a positive net present value. It is worth considering the company's current rate of growth when considering this expansion of capacity. Some capacity expansion will be required for the company to maintain its current 8% growth rate. The additional revenues in 2009 if Hansson has capacity to meet them will be $54 million. By the fourth year, the company at its current growth rate will have revenues of $926 million, an increase of $245 million over current levels. This would be more than the project is estimated to yield from the contract. Thus, it is worth considering that Hansson would probably benefit from this expansion anyway, if…