Homework answers / question archive / Veronica Sarkozy, the CFO for the firm PSUWC Designer Jeans Company, LLC, woke up with a start at 4:00 am on 5/2/2022, due to the phone ringing

Veronica Sarkozy, the CFO for the firm PSUWC Designer Jeans Company, LLC, woke up with a start at 4:00 am on 5/2/2022, due to the phone ringing

Finance

Share With

---

Veronica Sarkozy, the CFO for the firm PSUWC Designer Jeans Company, LLC, woke up with

a start at 4:00 am on 5/2/2022, due to the phone ringing. It was the firms senior financial

analyst, vacationing in Europe, calling with bad news. Veronica was supposed to present the project evaluation, at the end of the week, for the Board's proposal that they invest in new equipment which would enable them to add a new product line. Currently PSUWC has four successful products and they are considering selling a new Designer Jeans line.

The staff of financial analysts had been working hard over the last few weeks collecting data

and had prepared a model creating a financial forecast about the proposed project's viability.

Disaster had struck on the night of 5/1/2022 wherein malware all but wiped out the work of the

analysts. Veronica needed to prepare a financial analysis of the project to present the Board

with recommendations. All the staff had already left for their annual vacation and Veronica

was working alone. Veronica quickly reached the office and managed to salvage what was left

of the excel spreadsheet prepared for the presentation. What follows is some basic

information that Veronica knew and was able to retrieve about the project.

PSUWC's existing plant has excess capacity, in a fully depreciated building, to install and run the new equipment to produce the new Designer Jeans line. Due to relatively rapid advances in technology, the project was expected to be discontinued in four years.

The new Designer Jeans was expected to sell for $ 115 per unit and had projected sales of

5100 units in the first year, with a projected (Most-Likely scenario) 23.0 % growth rate per year for subsequent years. A total investment of $ 1,001,000 for new equipment was required.

The equipment had fixed maintenance contracts of $ 238,887 per year with a salvage value of

$ 144,836 and variable costs were 11 % of revenues. Veronica also needed to consider both the Best-Case and Worst-Case scenarios in the analysis with growth rates of 33.00 % and

2.30 % respectively.

The new equipment would be depreciated to zero using straight line depreciation. The new project required an increase in working capital of $ 198,250 and $ 39,650 of this increase would be offset with accounts payable.

PSUWC currently has 833000 shares of stock outstanding at a current price of $ 72.00. Even though the company has outstanding stock, it is not publicly traded and therefore there is no publicly available financial information. However, after analysis management believes that its equity beta is 0.85.

he company also has 110000 bonds outstanding, with a current price of $ 1,069.00. The

bonds pay interest semi-annually at a coupon rate of 3.80 %. The bonds have a par value of

$1,000 and will mature in 10 years. The average corporate tax rate was 30 %.

Management believes the S&P 500 is a reasonable proxy for the market portfolio. Therefore, the cost of equity is calculated using the company's equity beta and the market risk premium based on the S&P 500 annual expected rate of return - Veronica would calculate the monthly expected market return using 5 years of past monthly price data available in the worksheet Marketdata. This would then be multiplied by 12 to estimate the annual expected rate. Veronica remembered that if the expected rate of return for the market was too low, too high, or negative, a forward looking rate of an historical average of about 9.5% would have to be used, as the calculated value for the current 5-year period may not be representative of the

future. Veronica would consider a E(Rm) between 8-12% acceptable. Veronica would

calculate the market risk premium: E(Rm) - Rf from the previous calculations using the

risk-free rate data available in the worksheet Marketdata. Veronica noted that the risk-free

rate was on an annual basis.

Veronica needed to calculate the rate at which the project would have to be discounted to

calculate the Net Present Value (NPV) of the proposed project based on the decision of raising capital and the current capital market environment. This discount rate, the WACC,

would obviously influence the NPV and could affect the decision of whether to accept or reject the project. Thankfully, all the information needed to calculate this was available. Veronica needed to clearly show all the calculations and sources for all parameter estimates used in the calculation of the WACC (and ultimately the NPV).

Gathering all the available information, Veronica got a large cup of extra strong coffee and sat down to work on the development of the Capital Budgeting project model. The correct recommendation to the board was critical to the future growth of the firm!

Veronica appreciated the detailed step by step instructions on the Worksheet 0.Case

Instructions - Luckily they were still available!!.