Section B:

Question 3 [25 marks]

The CEO of EG Inc. is always on the lookout for new opportunities. The company, a highly

profitable conglomerate, currently consists of three divisions: Oil & Gas, Sportswear, and Car

Production. In a recent meeting with EG’s top-level management, the CEO enthused about a

recent documentary about asteroid mining and now wants EG to launch a Space Exploration

division to benefit from the potential she perceives in this sector.

Unfortunately, EG’s Chief Financial Officer (CFO) has fallen ill and you have been asked to

evaluate this potential space exploration project. In her excitement, the CEO wants to move

quickly, and she has provided you with the following financial projections:

Year 0 1 2 3

Sales ($m) 0 150 200 240

Net working capital ($m) 0 30 40 45

• Assume Costs of Goods Sold are 75% of Sales

• The project requires a $1,000m (=$1 billion) investment in a production facility

at t=0; assume a useful life of 25 years and linear depreciation (starting at t=1)

• The corporate tax rate is 30%.

• After t=3, assume that annual free cash-flows will grow at a rate of 3% in

perpetuity

Furthermore, the CEO tells you that EG currently has an equity cost of capital of 10%, a debt

cost of capital of 5%, and the company is targeting a debt-to-equity ratio of 1.5. Before

leaving your office, the CEO specifically instructs you to use EG Inc.’s WACC to value the

project.

Before starting your analysis, you notice that the CFO’s assistant has sent you a brief email

titled “You may find this useful.” The email contains the following table:

Company Industry Equity

Beta

Debt Beta D/E Constant

D/E ratio?

Esson Oil & Gas 1.41 0.35 1.31 Yes

WMB Car Production 1.83 0.34 0.83 Yes

Three Stripes Sportswear 1.73 0.21 1.11 No

Swoosh Sportswear 1.84 0.24 1.19 Yes

Das Auto Car Production 1.68 0.41 0.74 No

Oilstat Oil & Gas 1.29 0.42 1.42 Yes

Galactica Space Exploration 3.50 0.50 0.25 Yes

Zero G Space Exploration 3.00 0.80 0.10 Yes

Footnotes:

1. EG’s equity cost of capital is 10% and its debt cost of capital is 5%

2. Always use EG’s debt cost of capital as an approximation for a project’s debt cost of

capital

3. Currently, long-term treasury bonds have a yield of 2%, long-term investment grade

corporate bonds have an average yield of 4%, and non-investment grade long-term

corporate bonds have an average yield of 7%.

4. The market risk premium is 5%.

a. Calculate the project’s annual free cash-flows (from t=0 to t=3). [7 marks]

b. Use the information provided by the CEO, including her specific instructions, to

calculate EG’s WACC. Use this WACC to calculate the project’s NPV using the

WACC method. [7 marks]

c. Is the method used in (b) correct? Motivate your answer. [4 marks]

d. Would you calculate the WACC differently? If so, calculate it, and re-calculate the

project’s NPV using the WACC method. Compare your answers to questions (b) and

(d). Are the NPVs different? If so, why are they different, and does the difference

affect the investment decision? Comment briefly. [7 marks]

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