Corporate Finance

Using WACC to value a project

The RFX series, that will include an embedded radio-frequency identification (RFID) tag, which is a miniature radio antenna and transponder that allows a package to be tracked much more efficiently and with fewer errors than standard bar codes.

Avco engineers expect the technology used in these products to become obsolete after four years. During the next four years, however, the marketing group expects annual sales of $60 million per year for this product line. Manufacturing costs and operating expenses are expected to be $25 million and $9 million, respectively, per year. Developing the product will require upfront R&D and marketing expenses of $6.67 million, together with a $24 million investment in equipment. The equipment will be obsolete in four years and will be depreciated via the

straight-line method over that period. Avco bills the majority of its customers in advance, and it expects no net working capital requirements for the project. Avco pays a corporate tax rate of 40%. Given this information, the spreadsheet in Table 18.1 forecasts the project's expected free cash flow.

18.1Given this information, the spreadsheet in Table forecasts the project's expected 2free cash flow.

The market risk of the RFX project is expected to be similar to that for the company's other lines of business. Thus, we can use Avco's equity and debt to determine the weighted average cost of capital for the new project. Table shows Avco's current market value 18.2The market risk of the RFX project is expected to be similar to that for the company's other lines of balance sheet and equity and debt costs of capital. Avco has built up $20 million in cash for business. Thus, we can use Avco's equity and debt to determine the weighted

o s t o f G o o d s S o l d ( 2 5 . 0 0 ) ( 2 5 . 0 0 ) ( 2 5 . 0 0 ) ( 2 5 . 0 0 )—Gross Profit3 3 5 . 0 0 3 5 . 0 0 3 5 . 0 0 3 5 . 0 0—4 O p e r a t i n g E x p e n s e s ( 6 . 6 7 ) ( 9 . 0 0 ) ( 9 . 0 0 ) ( 9 . 0 0 ) ( 9 . 0 0 )5 D e p r e c i a t i o n ( 6 . 0 0 ) ( 6 . 0 0 ) ( 6 . 0 0 ) ( 6 . 0 0 )—EBIT6 ( 6 . 6 7 ) 2 0 . 0 0 2 0 . 0 0 2 0 . 0 0 2 0 . 0 07 I n c o m e Ta x a t 4 0 % 2 . 6 7 ( 8 . 0 0 ) ( 8 . 0 0 ) ( 8 . 0 0 ) ( 8 . 0 0 )Unlevered Net Income8 (4.00) 12.00 12.00 12.00 12.00Free Cash Flow9 P l u s : D e p r e c i a t i o n 6 . 0 0 6 . 0 0 6 . 0 0 6 . 0 0—10 (24.00)Less: Capital Expenditures — — — —11 — — — —Le s s : I n c r e a s e s i n N W C —12 Fre e C a s h F l ow ( 2 8 . 0 0 ) 18 . 0 0 18 . 0 0 18 . 0 0 18 . 0 067718.2 The Weighted Average Cost of Capital Method 67718.2 The Weighted Average Cost of Capital Method

TABLE 18.2 Avco’s Current Market Value Balance Sheet ($

this project is a good idea—taking the project results in an NPV of 61.25 - 28 = $33.25 million for the firm.

To summarize, the key steps in the WACC valuation method are as follows:

1. Determine the free cash flow of the investment.

Summary of the WACC Method

1. Determine the free cash flow of the investment.
2. Compute the weighted average cost of capital using Eq. 18.1.
3. Compute the value of the investment, including the tax benefit of leverage, by discounting the free cash flow of the investment using the WACC.

To summarize, the key steps in the WACC valuation method are as follows:

1. Compute the weighted average cost of capital using Eq. 18.1.
2. Compute the value of the investment, including the tax benefit of leverage, by discounting the free cash flow of the investment.

Using the WACC (Weighted Average Cost of Capital) method, the corporate treasurer calculates the firm's WACC, which is then used as the companywide cost of capital.

The key steps in the WACC valuation method are as follows:

1. Determine the free cash flow of the investment.
2. Compute the weighted average cost of capital using Eq. 18.1.2.
3. Compute the value of the investment, including the tax benefit of leverage, by discounting the free cash flow of the investment using the WACC.
4. Compute the WACC for new investments that are of comparable risk to the rest of the firm and that will not alter the WACC. This rate can then be used throughout the firm as the companywide cost of capital.

Summary of the WACC Method:

1. Determine the free cash flow of the investment.
2. Compute the weighted average cost of capital using Eq. 18.1.2.
3. Compute the value of the investment, including the tax benefit of leverage, by discounting the free cash flow of the investment using the WACC.

by dis-3. Compute2 - Compute the weighted average cost of capital using Eq. 18.1.counting the free cash flow of the investment using the WACC.

3 - Compute t