Illingham Packaging is a firm that manufactures and distributes corrugated cardboard containers. Much of its business is focused on producing customized containers in small production runs. Over the past few years the demand for the company’s product has been quite strong and recently the company has had to turn down some orders from its best customers due to lack of capacity. The company is therefore considering expanding its capacity by purchasing a new machine, the CX700. Unfortunately, the addition of this machine in Illingham’s plant will take several months and will partially disrupt production. The direct cost of CX700 is $1,760,000. The company has cash sufficient to purchase the machine at this price and so no outside financing is needed. If the company chooses not to purchase the machine, it will immediately pay out this cash to shareholders in the form of dividends.,The following page gives forecasts of Illingham’s current balance sheet together with forecasts of Illingham’s income for the next ten years under the assumption that Illingham does not purchase the machine. Even without the new machine, overall capacity and sales will grow due to other planned improvements in the production process for its other products and divisions.,It is mid-2012 and the firm has just completed a $50,000 feasibility study to analyze the CX700 proposal. The different functional groups within the firm have produced the following estimates:,• Marketing : Increased sales of $10M per year.,• Operations: Cost of goods sold = 70% of revenue ($7M per year), disruption caused by installation in 2012 will decrease sales by $5M, expansion will require increased inventory on hand of $1M during the life of the project.,• Human Resources: Additional personnel (sales & admin) costs of $2M per year.,• Accounting: CX700 will be depreciated straight-line over the 10-year life of the machine, corporate tax rate is 34%.,Suppose we have the following information regarding Illingham’s capital structure:,• Suppose Illingham has an equity beta of 0.91,Suppose the project has an asset beta = 0.70,• Illingham has a historic D/E ratio of 0.30, with an average rate of 6% paid on the debt,• The risk free interest rate is 5%, and the market risk premium is 6%,Discussion Questions,A. What effect will the purchase of the CX700 have on Illingham’s net income over the next 10 years? What effect will the purchase have on Illingham’s cash flows?,B. How would a more accelerated depreciation schedule affect earnings? How would it affect cash flows?,C. How would you evaluate the decision to purchase the CX700?,D. Suppose Illingham could use the CX700 to secure a loan of $1,000,000. What factors would you now consider in your decision?,E. Valuation using WACC,a. Suppose Illingham plans to maintain a constant D/E ratio of 0.30 going forward.,b. Estimate the value of the CX700 project using WACC,F. Valuation using APV,a. Suppose instead that the CX700 will be purchased using secured debt (which would not otherwise be issued).,b. Suppose Illingham borrows $1 M at a 6% interest rate.,c. What is your estimate of the value of the project now?,[Hint:,Step 1: Derive the project’s incremental FCF by filling in the missing values on the incremental net income statement on page 5 and incremental FCF statement on page 6.,Step 2: Calculate the appropriate discount factor, using either the WACC or the APV approach.,Step 3: Discount the FCF using the discount factor from Step 2.,Step 4: For APV, add the present value of tax shield. ]
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