Dinky Toys Case Study

Dinky Company produces small gadgets with brief economic lives. They have received firm commitments for one of their products in development, with a market life of the next three years. In order to begin production, Dinky must purchase additional machinery and lease additional production facilities. We will use the NPV to determine whether or not initiating production is in the best interest of Dinky Company.

Question 1: Calculate Dinky’s weighted average cost of capital using market weights for each financing component

Due to the fact that Dinky Company is a levered firm, that is, financed by both debt and equity we must find the cost of financing for both the debt and the equity portions of the firm. The cost of capital is found by taking a weighted average of the cost of debt, and the cost of equity. In order to find the weights of the debt and equity we must first calculate the market value using the book values given. In order to find the market value of the equity we multiplied the book value of the common stock by the multiplicator and added the retained earnings. To find the market value of the debt we used the book value and found a yield to maturity of nine years and then compared it to the market value of similar bonds with a maturity of 20 years. We were given the tax rate of 34%, which we subtract from one and multiply times the cost of debt to find the after tax cost of debt. The only other missing variable left was beta; we used the pure play method to find the beta based on the industry average beta. Our final WACC was 13.3%.

Question 2: Prepare a schedule showing the project’s annual, incremental, after-tax cash flows.

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In order to prepare the schedule of cash flows, we had to take into consideration certain costs. Since the 12500 square feet factory space leased from AmeriLease Corporation is already unused and there is no foreseeable use in the future, it’s a sunk cost and we did not use it in our cash flows. On the other hand 25,000 square feet in total will be needed, so an additional 12,500, (25,000-12,500) is necessary to complete the project and is an incremental cost that is taken into consideration. We were given that there was an initial working capital need of $100,000, this number remains unchanged the first year because it is exactly 10% of sales, the second year it increases by $60,000, and then it decreases by $50,000 in the third year. At the end of year three, because the project is at the end of its useful life we recuperate the $110,000. The initial investment is paid out in year 0, so there was no reason to discount this cash flow. The general overhead was not included because there are no incremental cash outflows incurred, that is whether or not the project is accepted the same amount of overhead will be charged to the company therefore the decision of whether or