Northline: Project NPV, Delay Option, and Buyback Financing
Northline Manufacturing, with EBITDA of $150 million and debt of $300 million, is at its target leverage of 2.0x. The board is considering a $200 million project that would add $30 million of annual EBIT in perpetuity, starting in one year. The project's risk is the same as the firm's. Northline's target capital structure is 40% debt and 60% equity. The pre-tax cost of debt is 6%, the equity cost is 12.5%, and the tax rate is 25%. The board also wants to return $100 million to shareholders through a buyback, funded with new debt, and believes the project's EBITDA will support additional debt capacity. A rival bidder may force Northline to decide within one year; if it waits, the project's expected EBIT will be $45 million with probability 0.6 and $10 million with probability 0.4, but the $200 million investment cost will be unchanged. Management's bonus is tied to EPS.
1. Calculate the project's NPV using WACC and recommend whether to invest now. Show the WACC calculation.
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WACC = w_d x r_d x (1 - t) + w_e x r_e = 0.40 x 6% x 0.75 + 0.60 x 12.5% = 1.8% + 7.5% = 9.3%. Project NOPAT = EBIT x (1 - t) = 30 x 0.75 = $22.5m. Perpetuity value = 22.5/0.093 = $241.94m. NPV = 241.94 - 200 = $41.94m. The project IRR is 22.5/200 = 11.25%, above the 9.3% WACC. On these assumptions, invest now.
Two caveats matter. First, the project's debt capacity at the target 40% is $80m, but at the firm's 2.0x EBITDA leverage target, $30m of EBITDA supports only $60m of debt. That inconsistency affects financing but not the all-equity WACC NPV. Second, confirm that the $30m is EBIT, not EBITDA, and that no working capital or maintenance capex is required. If the $30m were EBITDA, the NPV would be higher; the prompt says EBIT, so use NOPAT.
2. Value the option to delay one year. Should Northline wait? Assume the decision is made after the EBIT outcome is known and the appropriate discount rate is 9.3%.
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At year 1, high demand gives EBIT of $45m, NOPAT of $33.75m, and value = 33.75/0.093 = $362.90m. After the $200m investment, the payoff is $162.90m. Low demand gives EBIT of $10m, NOPAT of $7.5m, and value = 7.5/0.093 = $80.65m; the NPV is $80.65m - $200m = -$119.35m, so do not invest and the payoff is zero.
The expected payoff at year 1 is 0.6 x 162.90 + 0.4 x 0 = $97.74m. Discounting one year at 9.3% gives $97.74/1.093 = $89.42m. The option to wait is worth $89.42m, versus $41.94m for investing now. Waiting adds $47.48m in value, so wait if Northline has exclusive rights and can defer without losing the project. The option is valuable because management can avoid the bad state. But the rival bidder may erode exclusivity; if waiting risks losing the project, compare the strategic value of immediate investment with the option value. Using 9.3% for the option payoff is a simplifying assumption; the option's risk may warrant a different rate.
3. Assess the proposed $100 million buyback. Address leverage, covenant and rating, project financing, and the EPS-linked bonus.
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Current leverage is 300/150 = 2.0x. A $100m debt-funded buyback raises debt to $400m and, before the project, leverage to 2.67x, well above target. With the project adding $30m EBITDA, debt is $400m and EBITDA is $180m, giving 2.22x, still above 2.0x. If the project is also 40% debt-financed with $80m, debt becomes $480m and EBITDA is $180m, giving 2.67x. At the 2.0x target, the project supports only $60m of incremental debt (2.0 x 30), not $80m, so the financing plan is internally inconsistent.
The buyback does not create operating value; it transfers cash to shareholders and increases financial risk. It may raise EPS by reducing the share count, and management's EPS-linked bonus creates a conflict: managers may favor buybacks even when they crowd out the positive-NPV project or weaken the balance sheet. Recommendation: fund the project first, size any buyback to remain within 2.0x (roughly $60m of new debt capacity after the project, less project debt), preserve rating headroom, and disclose the bonus conflict to the board. If a buyback is pursued, use excess cash or equity rather than debt, and stress-test EBITDA downside.