The owner of Hansson Private Label (HPL) must determine whether or not to accept an aggressive expansion project that would preclude the company from pursuing any alternative investment opportunities for several years. The investment, if successful, would offer numerous benefits to the company, capturing greater market share, strengthening relationships with major customers, crowding out competition and increasing firm value. Nonetheless, the decision carries significant risks and could lead to a substantial decline in firm value, if not bankruptcy, should any number of variables prove unfavorable to HPL. Moreover, the project relies heavily on a contract with a single large customer. Given the high level of risk and relatively low return associated with the project, despite a positive NPV based on pro forma cash flows, I would strongly recommend the firm consider alternative investment opportunities. Problem Being Examined
Tucker Hansson owns Hansson Private Label, a 15-year-old private company that manufactures personal care products sold under the brand labels of retail partners. Hansson is faced with evaluating a proposal that calls for an investment of nearly $60 million, representing the greatest expansion the firm would undergo in a decade. The decision to proceed with expansion carries with it many potential upsides: HPL stands to expand and solidify its relationship with its largest customer, grow other customer relationships and usurp market share from the competition all while adding value to the firm. The expansion project, however, is not without significant risk. For one, this single investment would close off all other investment opportunities for the foreseeable future. Furthermore, pursuing the project would raise HPL’s debt to the highest levels Hansson is willing to assume in addition to maxing out the firm’s management capacity. Lastly, the investment would add substantially to the firm’s annual fixed costs, increasing the potential for financial distress should the firm experience an increase in costs, decrease in sales, or combination of the two. For Hansson, personally, the investment would represent yet a further concentration of his personal wealth, and thus risk, in the company. Hansson must evaluate the potential increase in firm value the expansion stands to generate, the level of acceptable risk to assume, how to assuage some of that risk, and how to proceed in the event that projections fall short or unforeseen risks materialize. Analysis
For the purposes of my analysis, I rejected Hansson’s notion that the proposed project should be evaluated using the historical WACC as the discount rate. Since taking on the project would significantly change the risk profile of the firm, I relied on Dowling’s estimated WACC of 9.38% in Exhibit 7 for a D/V ratio of 20.0% (closest to the estimated new D/V of 20.9%). Having used the CAPM formula to verify Dowling’s calculations, I was convinced of their accuracy. Since the WACC estimate relies on several assumptions and can have a profound effect on the profitability of the project, I evaluated the change in NPV using discount rates ranging from 8.5% to 10.5%—a range I felt was wide enough to account for any inaccuracies. Although the NPV decreased when a higher discount rate was applied, all projected NPV’s within that range remained positive; hence, the choice of discount rate did not have a major bearing on my final recommendation for HPL.
When calculating annual after-tax cash flows, I included all costs identified in Exhibit 5 in my calculation of the COGS. Since all figures in Exhibit 5 are assumed to be incremental to this project, it was necessary to include not only the direct costs of raw materials and hourly labor, but also the indirect costs of salaried labor, manufacturing overhead and maintenance expense, in my cash flow analysis.
As highlighted in Appendix A, I calculated the NPV...