GF520 Unit 10 Clean-Room Expansion Finance Report Example

Build It, Fund It With a Loan and Deferred Buybacks: A Unit 10 Corporate Finance Report on a Clean-Room Expansion

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Purdue University Global

GF520: Corporate Finance

Unit 10 Corporate Finance Report

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[Date]

The contract manufacturer, its customer and every figure are composite and illustrative; the articles and textbook cited are real.

Executive Summary

Build the expansion. At a project discount rate of 9.6 percent it has a net present value of about $14.4 million. Fund it with a $55 million seven-year term loan and $30 million of cash now set aside for share repurchases, deferring the buyback program by two years. This mix keeps net debt below 2.4 times EBITDA at its peak, falling below 1.9 times once the expansion earns, avoids diluting shareholders and preserves an investment-grade profile. Construction should begin only after the anchor customer renews its supply contract.

Background

The company molds, assembles and sterilizes components for medical device makers, earning EBITDA of about $48 million. Its largest customer, a maker of insulin pumps, has asked it to add capacity for a new pump model, which would require a second ISO class 7 clean room, new molding cells and expanded sterilization capacity. Construction would take about eighteen months. Today the company carries $60 million of debt, holds $31.2 million of cash, has net debt of $28.8 million, or 0.6 times EBITDA, and had planned to repurchase $30 million of shares this year.

Section 1: The Investment

Cash flows. Spending of $50 million in the first year and $35 million in the second. Incremental EBITDA of about $5.9 million in year 2, as the line ramps up, and $13.2 million a year from year 3. Depreciation over fifteen years, tax at 24 percent and $3 million of added working capital. After tax, the project generates about $11.4 million a year from year 3. A terminal value in year 10 assumes cash flow grows 1.5 percent a year thereafter, after $3 million a year of maintenance spending.

Discount rate. Company-wide, the blended cost of capital sits near 8.6 percent. This project carries more risk than the company's typical work, since it serves one customer and one product, so a premium of one percentage point is added, giving 9.6 percent. Research shows that firms using one company-wide rate for all projects tend to overinvest in risky divisions and underinvest in safe ones (Krüger et al., 2015); a project-specific rate avoids that error.

Results. Net present value of about $14.4 million at 9.6 percent. At the company-wide 8.6 percent it would be about $26.7 million, which overstates the value by not charging for customer concentration.

Section 2: What the Value Depends On

Three tests show where the answer is fragile.

Customer volume. If incremental EBITDA is 20 percent below forecast, because the new pump sells less than expected, net present value falls to about negative $5.9 million. This is the decisive risk.

Terminal value. About $41 million of present value, roughly 43 percent of the project's discounted inflows, comes from years after year 10. If cash flow after year 10 does not grow at all, net present value falls to about $7.3 million, still positive.

Discount rate. The project remains positive at any rate below roughly 10.8 percent.

The expansion is valuable if the anchor customer stays and loses value if its volume falls by a fifth, so the decision to build is really a decision about that customer, which is why the contract renewal must come before the first dollar of construction.

Section 3: Three Ways to Pay

Option A: all debt. Borrow $85 million and proceed with the $30 million buyback. Net debt would rise to about $143.8 million, 3.0 times current EBITDA, likely costing the company its investment-grade profile. Interest coverage would fall to about 5.0 times.

Option B: all equity. Issue $85 million of new shares, about 9 percent of the company's $945 million market value, and proceed with the buyback. Net debt would stay near 1.2 times EBITDA, but issuing shares while buying them back makes little sense, and new issues are usually received poorly because investors suspect managers sell shares when they believe them overvalued (Myers, 1984).

Option C: mixed. Borrow $55 million and use the $30 million earmarked for repurchases. Net debt would peak at about $113.8 million, 2.4 times current EBITDA, and fall below 1.9 times when the expansion's EBITDA arrives. Interest coverage would be about 6.4 times at the peak and about 8.2 times once the project earns.

Section 4: Why Option C

Option C follows the order in which companies usually prefer to raise money: internal cash first, then debt, with new equity last (Myers, 1984). It keeps debt within the range the previous capital structure analysis found sensible, preserving room to borrow if the customer relationship sours. And it avoids dilution. Its cost is deferring the buyback, which shareholders may notice, but repurchases were always meant to return surplus cash, and for two years there will be none.

Section 5: Payout

The regular dividend should continue unchanged. The board's previous commitment to a steady dividend is worth more than the cash a cut would save, and payout research finds that managers treat dividend levels as commitments while using repurchases to absorb changes in cash needs (Brealey et al., 2023). Repurchases should resume once net debt falls below 1.5 times EBITDA.

What the Board Gives Up

Choosing Option C is not free. Shareholders who expected $30 million of repurchases this year will wait two years, and some may read the deferral as caution about the business. The answer is to explain the trade plainly: the cash is being put to work at an expected return above its cost, in a project the company's largest customer has asked for. The board also gives up some flexibility. With net debt near 2.4 times EBITDA at the peak, a second large project in the next two years would need equity or would have to wait. Management's current plan contains no such project, but the constraint should be stated now rather than discovered later. Finally, concentration rises: the anchor customer, already about a third of revenue, would supply close to half once the new line runs at capacity, which makes the renewal condition below essential rather than cautious.

Conditions

1. The anchor customer must renew its supply agreement for at least seven years, with minimum volumes covering at least 80 percent of forecast, before construction begins.

2. The term loan should include an amortization schedule matched to the project's ramp-up, with the first principal payment in year 3.

3. Management should report quarterly on construction cost against the $85 million budget, with board approval required for any overrun above 10 percent.

Limits

The forecast depends on one customer's product, which may change with regulation or competition. Construction costs for clean rooms can run over. The terminal value assumes the relationship continues beyond year 10.

References

Brealey, R. A., Myers, S. C., & Allen, F. (2023). Principles of corporate finance (14th ed.). McGraw Hill.

Krüger, P., Landier, A., & Thesmar, D. (2015). The WACC fallacy: The real effects of using a unique discount rate. The Journal of Finance, 70(3), 1253-1285. https://doi.org/10.1111/jofi.12250

Myers, S. C. (1984). The capital structure puzzle. The Journal of Finance, 39(3), 574-592. https://doi.org/10.1111/j.1540-6261.1984.tb03646.x