FIN – Lampkin Manufacturing Company

PROJECT-SPECIFIC WACC USING CORPORATE FINANCING Lampkin ManufacturingCompany has two projects.The rst, Project A, involves the construction of an additionto the rms primary manufacturing facility.The plant expansion will add xed operatingcosts equal to $200,000,000 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 rm in Silicon Valley. Project B has lower xed costs of only $50,000 per year, andthus lower operating leverage than Project A, while its variable costs are much higher at40% of sales.Finally,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 rm should use to evaluatethe two projects, Lampkins CFO, Paul Keown, called his old friend Arthur Laux, whoworks for Lampkins investment banker.Art, were trying to decide which of two major investments we should undertake,and I need your assessment of our firms capital costs and the debt capacities of bothprojects. Ive asked my assistant to e-mail you descriptions of each. We need toexpand the capacity of our manufacturing facility, and these two projects representvery different approaches to accomplishing that task. Project A involves a traditionalplant expansion totaling $3.2 million, while Project B relies heavily on outsourcingarrangements and will cost us a little more up front, $3.4 million, but will have muchlower fixed operating costs each year. What I want to know is, how much debt can weuse to finance each project without putting our credit rating in jeopardy? I realizethat this is a very subjective thing, but I also know that you have some very brightanalysts who can provide us with valuable insight.Art replied:Paul, I dont know the answers to your questions right off the top of my head, but Ill putsome of our analysts on it and get back to you tomorrow at the latest.The next day,Art left the following voice-mail message for Paul:Paul, Ive got suggestions for you regarding the debt-carrying capacity of your projectsand current capital costs for Lampkin. Our guys think that youve probably got roomfor about $1,200,000 in new borrowing if you do the traditional plant expansion project(i.e., 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 agencies. Moreover,if the credit agencies cooperate as expected, we can place that debt for you with a yieldof 5%. Our analysts also did a study of your rms cost of equity and estimate that it isabout 10% right now. Give me a call if I can be of additional help to you.a. Assuming that Lampkins investment banker is correct,use book value weights to estimate the project-specic costs of capital for the two projects.(Hint:The only differencein the WACC calculations relates to the debt capacities for the two projects.)b. How would your analysis of the project-specic WACCs be affected if LampkinsCEO decided that he wanted to delever the rm by using equity to nance the betterof the two alternatives (i.e.,Project A or B)?PROBLEM 5.8GivenCost of equityCost of debtTax rate10.00%5.00%35.00%Solutiona.Project A (expand)Up-front initial investmentAnnual fixed costsVariable costsContribution marginDegree of Operating LeverageDebt capacityDebt to value ratio at capacityProject WACCProject B (outsource)Up-front initial investmentAnnual fixed costsVariable costsContribution marginDegree of Operating LeverageDebt capacityDebt to value ratio at capacityProject WACCSolution Legend$3,200,000$200,00020.00%80.00%high$1,200,00037.50% Is this correct?8.13%$3,400,000$50,00040.00%60.00%low$2,400,00070.59%6.47%b. How would your analysis of the project-specificWACCs be affected if Lampkin’s CEO decided thathe wanted to delever the firm by using equity tofiance the better of the two alternatives(IE A or B)?= Value given in problem= Formula/Calculation/Analysis required= Qualitative analysis or Short answer required= Goal Seek or Solver cell= Crystal Ball Input= Crystal Ball Output