The American Centrifuge Project - Report Example

THE USEC INC CASE TABLE OF CONTENTS Executive Summary…………….3 2. Main report……………………...5 Why is USEC pursuing ACP?......5 What is the net present value (NPV) of the American Centrifuge project ( ACP) currently implied by the stock market?.........5 What is USEC’s weighted average cost of capital (WACC) in July 2006? Am I comfortable with using this discount rate for the ACP?.............6 Net Present Value of the American Centrifuge Project:………7 Key value drivers…………..8 Is Mackovjak correct to ignore that the market value of USEC’s inventory of uranium exceeds its book value?...........9 Based on my analysis, would I recommend that Rivanna Capital take a long, short, or no position in USEC’s stock? …………….10 3. Exhibits…………….11 4. References……….22 1. EXECUTIVE SUMMARY USEC is pursuing the American Centrifuge Project (ACP) because it will give it a technological and cost leadership over its competitors. The cost efficiencies realised from ACP will make it the lowest cost producer in the uranium enrichment industry. The technology used in the centrifuge project will cut down the electricity consumption in the enrichment process by a whopping 95%.This will bring down the overall enrichment costs by 50%. The current stock price does not include the expectations about ACP in which USEC is making massive investments. Therefore, the Net Present Value (NPV) of ACP implied by the current stock price of USEC is zero. The Weighted Average Cost of Capital (WACC) comes out to be 10.6515%. This discount rate is used for the ACP project because the key assumption is that that the capital structure of the ACP project will be the same as the current capital structure of USEC. This current capital structure of USEC has 34.36% debt and 65.64% equity. This means that $1.7 billion required for the ACP project will be financed through $584.12 million of debt (34.36%) and $1014.239 million of equity (65.64%). The debt will be raised by floating corporate bonds at the interest rates of 7.75% (which is the interest rate on the current debt of USEC. The amount of $1014.239 can be raised by issuing 103.32 million equity shares at the current market price of $10.80 The NPV of the ACP comes out to be $323.0422 million. The key value driver of the NPV is the demand for Separate Work Units (SWU). It has been assumed by USEC that there will be 100% demand which will enable the ACP to operate at 100% production capacity. The sensitivity analysis shows that for every 1% decrease in demand, the NPV comes down by 2.74%. It is therefore recommended that Rivanna capital should take a long position in the project. This is because the stock price, after considering the ACP project, is undervalued by a massive 49.53% and Rivanna’s rule is to go long on any stock that is undervalued by 10% or more. 2. MAIN REPORT 2.1 The pursuit of ACP by USEC USEC is pursuing ACP because it will give it an edge technologically and cost-wise over its competitors. The cost efficiencies realised from ACP will make it the lowest cost producer in the uranium enrichment industry. The existing uranium enrichment process of USEC at the Paducah plant uses the gas diffusion process. This process requires intensive electricity power for operating a series of enormous industrial compressors. USEC has kept the cost of this electricity constant through a long term electricity contract. However, this contract will expire soon. After the expiry of this contract, the cost of production will rise and this will have a very negative impact on the profit margins of USEC. Consequently, USEC is very keen on pursuing the American Centrifuge project. The technology used in the centrifuge project will cut down the electricity consumption in the enrichment process by a whopping 95%.This would bring down the overall enrichment costs by 50%. The low costs mean higher profit margins for USEC. ACP will also double the scale of USEC and has the potential to dramatically improve the competitive position of USEC. 2.2 Net present value (NPV) of ACP currently implied by the stock market The current stock price of USEC is $10.80. This stock price fairly reflects the expectations of USEC’s existing operations as well as the future growth of these operations. However, they do not include the expectations about the ACP in which USEC is making massive investments. Therefore, NPV of ACP as implied by the current stock price of USEC is zero. 2.3 USEC’s Weighted Average Cost of Capital (WACC) in July 2006. Weighted Average Cost of Capital of USEC in July 2006 The current risk free rate (Rf) 5.02% Market risk premium 5.50% Beta ( β) 1.3 Using the Capital Asset Pricing Model (CAPM), cost of equity ke = Rf + β * Market risk premium Therefore, cost of equity (ke) = 0.1217 Cost of debt (kd) 0.0775 size of debt in million dollars 475 size of equity in million dollars 907.6 Weighted Average Cost of Capital of USEC in July 2006 = Cost of debt *[debt/(debt + equity)] + cost of equity *[ equity/(debt + equity)] Therefore WACC of USEC in July 2006 0.106515 Note: The capital asset pricing model (CAPM) has been used in the above calculations to calculate the cost of equity. According to CAPM, Cost of equity is: Cost of equity (ke) = Rf + β * Market risk premium The risk free rate has been taken to be 5.02% which is the current yield on six month treasury bonds as of 21st July, 2006. The market risk premium has been taken to be 5.50%. Ben Mackovjak is confident that the market risk premium will be between 5% and 6%. Therefore, I have assumed the average of the two to put market risk premium at 5.5%. The Beta of 1.3 is the one given at the end of the case study for USEC. This Beta is based on the five year monthly Beta of USEC. Using above discount rate for the ACP I am comfortable with using this discount rate for the ACP, because the specific project risks for the ACP do not seem to be much different from the risks of the current UPSEC uranium enrichment facilities. The discount rate takes in the current market premium and will therefore lead to a fair valuation of the NPV of the ACP project. The main assumption behind using this discount rate for the ACP will be that the capital structure (debt to equity) ratio for the American centrifuge project will be the same as for the rest of USEC. This current capital structure of USEC has 34.36% debt and 65.64% equity. This means that $1.7 billion required for the ACP project will be financed through $584.12 million of debt (34.36%) and $1014.239 million of equity (65.64%). The debt will be raised by floating corporate bonds at the interest rates of 7.75% (which is the interest rate on the current debt of USEC). The amount of $1014.239 can be raised by issuing 103.32 million equity shares at the current market price of $10.80 The risk free rate used for calculating the required return on equity is the six month rate on the treasury bonds given at the end of the case study. This is 5.02%. The case study also gives yields on treasury bonds for three years, five years, 10 years and 30 years. The average of these yields also approximates to around 5.02%. Therefore, the same required return on equity and WACC has been used for each of the fifteen years of the life of ACP. 2.4 Estimated NPV of the American Centrifuge Project The net present value of the ACP works out as $323.022 million. The positive NPV means that the project will end up creating value (Prasanna Chandra, 2008). The value of costs of goods sold, selling and administrative expenses etc. have been calculated based on the average ratios as a percentage of sales for the past years of USEC. However, because of the assumption that costs in the ACP project will be 50% less, the cost of goods sold has been taken to be 45.87% of the revenues instead of the current average of 91.74% . The inflation rate has been put at 3% and discount rate has been put at the WACC which is 10.6515%. Note: For the detailed calculation of the NPV, see Exhibit 1. 2.5 Key value drivers The key value driver of NPV is the demand for SWU. It has been assumed that demand will allow the ACP to operate at full capacity i.e. demand is 100% of production capacity. If the demand changes by 10% and comes down to 90% of the total production capacity of the ACP, the net Present value will come down to $234.6419 million i.e. for a change in 10% in demand, the corresponding change in NPV is 27.36% [ ((323.0422-234.6419) / 323.0422 ) * 100 = 27.36%]. If the actual demand comes down to 80% of the full production capacity of the ACP, then the NCP comes down to $ 146.2407 million i.e. for a 20% change in demand, the NPV changes by 54.73% Therefore, for over 1% change in demand, the NPV changes by 2.74%. The results given below of the sensitivity analysis can be verified by putting the inputs for the various demand levels in the financial model given in Exhibit 1 of section 3 of this report Sensitivity Analysis Demand 100% NPV 323.0422 Demand 90% NPV 234.6419 Demand 80% NPV 146.2407 2.6 Is Mackovjak correct to ignore that the market value of USEC’s inventory of uranium exceeds its book value? In my opinion Mackovjak is not correct in ignoring the market value of USEC inventory. For the purpose of valuations, it is best to consider the fair market value of all the assets. 2.7 Rivanna Capital’s position in USEC’s stock NPV of the ACP for the shareholders = $323.0422 million. The Enterprise value comes out to be (Total present value of the inflows) = $1598.359 million. Equity value = Enterprise value – value of debt. Value of debt raised for ACP project = $584.12 million (34.36% of the total capital requirement of $1.7 billion) Therefore equity value = 1598.359m – $584.12m = $ 1014.239 million Total number of outstanding shares of USEC in July 2006 = $85.94 million For raising the remaining $1115.88 million required for the ACP project, USEC will need to issue at the current market rate of $10.80, $103.32 million more equity shares. Therefore total number of equity shares after the issuance = $103.32m + $85.94m = $189.26 million. Total equity value created by the ACP for the shareholders = $1014.239 million. Therefore equity value created per share by the ACP project = $1014.239/ $189.26 = $5.35. [Total equity value created / total number of outstanding shares] Therefore, if the ACP project is included in the valuation, the fair value of the USEC share will be $10.80 + $5.35 = $16.15 Therefore the USEC stock is undervalued by ($16.15 - $10.80)/ $10.80 = 49.53%) The investment rule of Rivanna capital is to take a long position in those stocks that are undervalued by 10% or more. We can see that after including ACP, the stock of USEC is undervalued by a whopping 49.53%. Hence, it is recommended that Rivanna Capital should take a long position in the USEC stock. Note: Total number of outstanding shares has been calculated from Exhibit 3 given of the case study: Liquidation value = $438.3 million. Liquidation value per share = $5.1. Therefore, total number of outstanding shares will be = Liquidation value/ Liquidation value per share = $438.3m/ $5.1 = $85.94 million outstanding shares. 3. EXHIBITS Exhibit 1 Detailed calculation of the NPV of American Centrifuge Project Calculation of NPV of ACP Cash outflows in the beginning of 2006 100 2006 185 2007 300 2008 350 2009 350 2010 450 WACC 0.106515 Present value of the cash outflows in July 2006 = 100 + 185/( 1+ .106515) + 300/ ( 1+.106515)^2+ 350/(1+.106515)^3+350/(1+.106515)^4+450/(1+.106515)^5 Present value of the cash outflows in July 2006 1275.316 Cash inflows calculations Cash inflows in 2011 Market price of SWU 127 Production of SWU produced in million pounds 2.5 revenues 317.5 less costs of goods sold 145.64 Selling & administrative expenses 12.6 others net 1.905 Royalty payments at 1% of gross revenues 3.175 Net income before taxes 154.18 provision for income taxes 61.98036 net income after taxes 92.19964 Add back depreciation 113 less working capital at 5% of sales 15.875 Free cash inflows in 2011 189.3246 Present value of the cash inflows of 2011 in 2006 = 189.3246/ (1+WACC)^6 Therefore present value of the cash inflows of 2011 in 2006 103.1486 Cash inflows in 2012 Inflation 0.03 market price 130.81 Production 4.5 Revenues 588.645 costs of goods sold 269.8937 selling and administrative expenses 22.95716 others net 3.53187 Royalty payments 5.88645 net income before taxes 286.3758 provision for taxes 115.1231 net income after taxes 171.2527 Add back depreciation 113 Less increase in working capital 13.55725 Free cash inflows 270.6955 Present value of the cash inflows of 2012 = 270.6955/(1+WACC)^7 Therefore present value will be 133.2846 Cash inflows in 2013 inflation 0.03 market price 134.7343 production 6.5 revenues 875.773 costs of goods sold 401.7171 selling and administrative expenses 34.15515 others net 5.254638 royalty payments 8.75773 net income before taxes 425.8884 provision for taxes 171.2071 net income after taxes 254.6813 Add back depreciation 113 less increase in working capital 14.3564 Free cash flows 353.3249 Present value of the cash inflows of 2013 = 353.3249/(1+WACC)^8 Therefore present value of the cash inflows of 2013 145.9764 Cash inflows in 2014 inflation 0.03 market price 138.7763 production 6.5 revenues 902.0461 costs of goods sold 413.7686 selling and administrative expenses 35.1798 others net 5.412277 royalty payments 9.020461 net income before taxes 438.665 provision for taxes 176.3433 net income after taxes 262.3217 Add back depreciation 113 less increase in working capital 1.313659 Free cash flows 374.008 present value of the free cashflows= 374.008/(1+WACC)^9 Therefore present value 150.406 Cash inflows in 2015 inflation 0.03 market price 142.9396 production 6.5 revenues 929.1075 costs of goods sold 426.1816 selling and administrative expenses 36.23519 others net 5.574645 royalty payments 9.291075 net income before taxes 451.825 provision for taxes 181.6336 net income after taxes 270.1913 Add back depreciation 113 less increase in working capital 1.353069 Free cash flows 381.8383 present value = 381.8383/(1+WACC)^10 present value 138.7735 Cash inflows in 2016 inflation 0.03 market price 147.2278 production 6.5 revenues 956.9807 costs of goods sold 438.9671 selling and administrative expenses 37.32225 others net 5.741884 royalty payments 9.569807 net income before taxes 465.3797 provision for taxes 187.0827 net income after taxes 278.2971 Add back depreciation 113 less increase in working capital 1.393661 Free cash flows 389.9034 present value = 389.9034/(1+WACC)^11 present value 128.0639 Cash inflows in 2017 inflation 0.03 market price 151.6446 production 6.5 revenues 985.6902 costs of goods sold 452.1361 selling and administrative expenses 38.44192 others net 5.914141 royalty payments 9.856902 net income before taxes 479.3411 provision for taxes 192.6951 net income after taxes 286.646 Add back depreciation 113 less increase in working capital 1.435471 Free cash flows 398.2105 present value = 398.2105/(1+WACC)^12 present value 118.2021 Cash inflows for 2018 inflation 0.03 market price 156.194 production 6.5 revenues 1015.261 costs of goods sold 465.7002 selling and administrative expenses 39.59517 others net 6.091565 royalty payments 10.15261 net income before taxes 493.7214 provision for taxes 198.476 net income after taxes 295.2454 Add back depreciation 113 less increase in working capital 1.478535 Free cash flows 406.7668 present value 109.119 Cash flows for 2019 inflation 0.03 market price 160.8798 production 6.5 revenues 1045.719 costs of goods sold 479.6712 selling and administrative expenses 40.78303 others net 6.274312 royalty payments 10.45719 net income before taxes 508.533 provision for taxes 204.4303 net income after taxes 304.1027 Add back depreciation 113 less increase in working capital 1.522891 Free cash flows 415.5798 present value 100.7517 Cash inflows for 2020 inflation 0.03 market price 165.7062 production 6.5 revenues 1077.09 costs of goods sold 494.0613 selling and administrative expenses 42.00652 others net 6.462542 royalty payments 10.7709 net income before taxes 523.789 provision for taxes 210.5632 net income after taxes 313.2258 Add back depreciation 113 less increase in working capital 1.568578 Free cash flows 424.6572 present value 93.04198 Cash inflows for 2021 inflation 0.03 market price 170.6774 production 6.5 revenues 1109.403 costs of goods sold 508.8831 selling and administrative expenses 43.26672 others net 6.656418 royalty payments 11.09403 net income before taxes 539.5027 provision for taxes 216.8801 net income after taxes 322.6226 Add back depreciation 113 less increase in working capital 1.615635 Free cash flows 434.007 present value 85.93692 Cash inflows for 2022 inflation 0.03 market price 175.7977 production 6.5 revenues 1142.685 costs of goods sold 524.1496 selling and administrative expenses 44.56472 others net 6.85611 royalty payments 11.42685 net income before taxes 555.6877 provision for taxes 223.3865 net income after taxes 332.3013 Add back depreciation 113 less increase in working capital 1.664104 Free cash flows 443.6372 present value 79.38779 Cash inflows for 2023 inflation 0.03 market price 181.0716 production 6.5 revenues 1176.966 costs of goods sold 539.8741 selling and administrative expenses 45.90166 others net 7.061794 royalty payments 11.76966 net income before taxes 572.3584 provision for taxes 230.0881 net income after taxes 342.2703 Add back depreciation 113 less increase in working capital 1.714028 Free cash flows 453.5563 present value 73.34993 Cash inflows for 2024 inflation 0.03 market price 186.5038 production 6.5 revenues 1212.275 costs of goods sold 556.0704 selling and administrative expenses 47.27871 interest expenses 0 others net 7.273647 royalty payments 12.12275 net income before taxes 589.5291 provision for taxes 236.9907 net income after taxes 352.5384 Add back depreciation 113 less increase in working capital 1.765448 Free cash flows 463.773 present value 67.78235 Cash inflows for 2025 inflation 0.03 market price 192.0989 production 6.5 revenues 1248.643 costs of goods sold 572.7525 selling and administrative expenses 48.69707 others net 7.491857 royalty payments 12.48643 net income before taxes 607.215 provision for taxes 244.1004 net income after taxes 363.1146 Add back depreciation 113 add release in working capital 62.43214 Free cash flows 538.5467 present value 71.13401 Total Present value of the cash inflows 1598.359 Present value of the cash outflows in July 2006 1275.316 Net present value of the American centrifuge project 323.0422 4 REFERENCES 1. Prasanna Chandra, 2008, Investment Analysis and Portfolio Management, McGraw-Hill. 2. Russell J. Fuller, J.L.Farrell, 2005, Modern Investments & Security Analysis McGraw-Hill Read More