Lampkin Manufacturing Company has two projects. The first, Project A, involves the construction of an addition to the firm's primary manufacturing facility. The plant expansion will add fixed operating costs equal to $200,000 per year and variable costs equal to 20% of sales. Project B, on the other hand, involves outsourcing the added manufacturing to a specialty manufacturing firm in Silicon Valley. Project B has lower fixed costs of only $50,000 per year, and thus lower operating leverage than Project A, while its variable costs are much higher, at 40% of sales. Project A has an initial cost of $3.2 million, while Project B will cost $3.4 million.
When the question arose as to what discount rates the firm should use to evaluate the two projects, Lampkin's CFO, Paul Keown, called his old friend Arthur Laux, who works for Lampkin's investment banker.
Art, we're trying to decide which of two major investments we should understake, and I need your assessment of our firm's capital costs and the debt capacities of both projects. I've asked my assistant to email you descriptions of each. We need to expand the capacity of our manufacturing facility, and these two projects represent very different approaches to accomplishing that task. Project A involves a traditional plant expansion totaling $3.2 million, while Project B relies heavily on outsourcing arrangements and will cost us a little more up front, $3.4 million, but will have much lower fixed operating costs each year. What I want to know is, How much debt can we use to finance each project without putting our credit rating in jeopardy? I realize that this is a very subjective thing, but I also know that you have some very bright analysts who can provide us with valuable insight.
Art replied:
Paul, I've got suggestions for you regarding the debt-carrying capacity of your projects and current capital costs for Lampkin. Our guys think that you've probably got room for about $1,200,000 in new borrowing if you do the traditional plant expansion project (Project A). If you decide on Project B, we estimate that you could borrow up to $2,400,000 without realizing serious pressure from the credit rating angencies. If the credit angencies cooperate as expected, we can place that debt for you with a yeild of 5%. Our analysts also did a study of your firm's cost of equity and estimate that it is about 10% right now. SHOW ALL WORK, ANSWER BOTH A AND B
A) Assuming that Lampkin's investment banker is correct, use book value weights to estimate the project-specific cost of capital for the two projects. (Hint: The only difference in the WACC calculations relates to the debt capacities for the two projects. Also, the firm's tax rate is 35%).
B) How would your analysis of project-specific WACCs be affected if Lamkin's CEO decided that he wanted to delever the firm by using equity to finance the better of the two alternatives (Project A or Project B)?
Cost of equity 10% Cost of debt 5% Tax rate 35%
Project A (expand) Up-front initial investment $3,200,000 Annual fixed costs $200,000 Variable costs 20% Contribution margin 80% Degree of Operating Leverage high Debt capacity $1,200,000 Debt to value ratio at capacity ? Project WACC ?
Project B (outsource) Up-front intitial investment $3,400,000 Annual fixed costs $50,000 Variable costs 40% Contribution margin 60% Degree of Operating Leverage low Debt capacity $2,400,000 Debt to value ratio at capacity ? Project WACC ?
Lampkin Manufacturing Company has two projects. The first, Project A, involves the construction of an addition to the firm's primary manufacturing facility. The plant expansion will add fixed operating costs equal to $200,000 per year and variable costs equal to 20% of sales. Project B, on the other hand, involves outsourcing the added manufacturing to a specialty manufacturing firm in Silicon Valley. Project B has lower fixed costs of only $50,000 per year, and thus lower operating leverage than Project A, while its variable costs are much higher, at 40% of sales. Project A has an initial cost of $3.2 million, while Project B will cost $3.4 million.
When the question arose as to what discount rates the firm should use to evaluate the two projects, Lampkin's CFO, Paul Keown, called his old friend Arthur Laux, who works for Lampkin's investment banker.
Art, we're trying to decide which of two major investments we should understake, and I need your assessment of our firm's capital costs and the debt capacities of both projects. I've asked my assistant to email you descriptions of each. We need to expand the capacity of our manufacturing facility, and these two projects represent very different approaches to accomplishing that task. Project A involves a traditional plant expansion totaling $3.2 million, while Project B relies heavily on outsourcing arrangements and will cost us a little more up front, $3.4 million, but will have much lower fixed operating costs each year. What I want to know is, How much debt can we use to finance each project without putting our credit rating in jeopardy? I realize that this is a very subjective thing, but I also know that you have some very bright analysts who can provide us with valuable insight.
Art replied:
Paul, I've got suggestions for you regarding the debt-carrying capacity of your projects and current capital costs for Lampkin. Our guys think that you've probably got room for about $1,200,000 in new borrowing if you do the traditional plant expansion project (Project A). If you decide on Project B, we estimate that you could borrow up to $2,400,000 without realizing serious pressure from the credit rating angencies. If the credit angencies cooperate as expected, we can place that debt for you with a yeild of 5%. Our analysts also did a study of your firm's cost of equity and estimate that it is about 10% right now. SHOW ALL WORK, ANSWER BOTH A AND B
A) Assuming that Lampkin's investment banker is correct, use book value weights to estimate the project-specific cost of capital for the two projects. (Hint: The only difference in the WACC calculations relates to the debt capacities for the two projects. Also, the firm's tax rate is 35%).
B) How would your analysis of project-specific WACCs be affected if Lamkin's CEO decided that he wanted to delever the firm by using equity to finance the better of the two alternatives (Project A or Project B)?
| Cost of equity | 10% |
| Cost of debt | 5% |
| Tax rate | 35% |
| Project A (expand) | |
| Up-front initial investment | $3,200,000 |
| Annual fixed costs | $200,000 |
| Variable costs | 20% |
| Contribution margin | 80% |
| Degree of Operating Leverage | high |
| Debt capacity | $1,200,000 |
| Debt to value ratio at capacity | ? |
| Project WACC | ? |
| Project B (outsource) | |
| Up-front intitial investment | $3,400,000 |
| Annual fixed costs | $50,000 |
| Variable costs | 40% |
| Contribution margin | 60% |
| Degree of Operating Leverage | low |
| Debt capacity | $2,400,000 |
| Debt to value ratio at capacity | ? |
| Project WACC | ? |
