Based in Winnipeg, Manitoba, Clearview Security Technologies Inc. (Clearview) was founded to provide security systems, f

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Based in Winnipeg, Manitoba, Clearview Security TechnologiesInc. (Clearview) was founded to provide security systems,facilities controls, and related services. Clearview established asolid reputation for quality and the business grew, thanks tostrong relationships with large long-term customers in Canada andthe United States. Clearview has experienced little competitivepressure in its core market and the company’s offerings arestandardized, enabled by significant technological and financialbarriers to entry.
The Research and Innovation Group (RIG) is the development sideof the company. Where Clearview’s primary lines are standardized,the RIG is all over the map. Clearview uses this smaller divisionto provide contract software and consulting to a wide range ofbusiness types.
The RIG is considering a new contract that will strain resourcesfor not only the RIG, but the entire company. The project involvesnew technology, a new customer, and a new geographic area. Thedirector of operations has warned you that it will be substantiallymore risky than anything Clearview does in its core business. Withan upfront cost of C$8.5 million, managers want to develop anunderstanding of expected financing costs. The director of financeexplained that understanding cost of capital will be a key part ofmaintaining and improving Clearview’s competitive edge. RIGmanagers have noticed competing bids for the contract and it isexpected that margins will be pushed down.
You have been asked to calculate the company’s weighted averagecost of capital (WACC), based on the following information. Overthe past five years the firm’s stock price and earnings have bothgrown at approximately 5 percent a year. Clearview recently paid adividend of $1.25 a share on earnings per share of $2.50 and thecommon shares trade at $45 per share with 250,000 sharesoutstanding. There are no preferred shares. You check the Bank ofCanada’s web page and the current 91-day T-bill yield is 1.25percent and the long Canada bond yield is 2.5 percent. On your deskis a series of reports by major investment banks that indicate along-run return on the Canadian equity market of 8 percent to 9percent a year, and a note that Clearview’s stock beta has beenabout 0.90. Clearview also has 25-year bonds outstanding with a$1,000 face value, 6.5 percent semi-annual coupon, and 20 years tomaturity. The bonds currently trade at 115. The initial bondoffering raised $15,500,000 and sold at par. The firm’s marginaltax rate is 30 percent.
1. The company will use its current capital structure to settarget weights for debt and equity, with flotation costs of 2percent for long-term debt and 7.5 percent for equity.
• How much capital must Clearview raise in order to cover theproject cost and all flotation charges?
2. Determining the NPV
The RIG project is expected to generate revenues of $1,400,000per year before tax, in each of the next 10 years. The PV (CCA taxshield) method for depreciation is appropriate using the half-yearrule. The applicable CCA rate is 30%, salvage value will be zero,and net working capital considerations are minimal. Determine theNPV of the project using the WACC calculated earlier as thediscount rate.
Rework the analysis in part a using a discount rate of 10%. Whatis the revised NPV of the project?
3. The RIG Project Decision
The director of finance asked you to discount the expectedfuture cash flows for the RIG project using Clearview’s WACC and todetermine the NPV of the project. The director remains confidentthat using Clearview’s WACC is appropriate because the WACCconsiders many key aspects of the business’s finances.
a. How should you respond?
b. What would be the justification for using a higher discountrate, as introduced in question 4 b?
c. Describe a situation where using a lower discount rate than afirm’s current WACC might be appropriate.
d. In considering the project’s value, should the CCA taxshields be valued using the same discount rate as the firm’safter-tax net revenues?