Megadeth Inc. is considering expanding its local private cemetery business natio
ID: 2782957 • Letter: M
Question
Megadeth Inc. is considering expanding its local private cemetery business nation-wide. According to co-CEOs Dave Mustaine and David Ellefson, the business is “looking up”. The expansion will provide a net cash inflow of $127,000 during the first year. Messrs. Mustaine and Ellefson expect cash flows to increase 4% per year indefinitely citing the rationale that “…death is a growing business”. The project requires an initial investment of $1,700,000.
If Megadeth Inc. requires an 11% hurdle rate for such undertakings, should they proceed with the private cemetery project?
Megadeth’s CFO, Kiko Loureiro, is somewhat unsure about the 4% perpetual growth rate and asks you to determine the break-even growth rate based on the 11% hurdle rate.
Explanation / Answer
It is given that the expansion will be a net cash inflow of $127,000 during the first year.
Initial project cost= $1,700,000
Required hurdle rate= 11%
Growth rate= 4%
By gordon growth model the present value of the perpetual cash flows can be calculated as= $127,000/(0.11-0.04)
=$1,814,285.71
As the present value of the future cash flows is greater than the initial investment of $1,700,000, so the company should proceed with the project.
It is also given that Megadeth’s CFO, Kiko Loureiro, is somewhat unsure about the 4% perpetual growth rate. Let the breakeven growth rate be g.
For breakeven, NPV= 0
So, $127,000/(0.11-g) - $1,700,000 = 0
or, g = 0.0353 or 3.53%