Burton,
a manufacturer of snowboards, is considering replacing an existing piece of
equipment with a more sophisticated machine. The following information is
given.
The proposed machine will cost $120,000 and have installation
costs of $15,000. It will be depreciated
using a 3 year MACRS recovery schedule.
It can be sold for $60,000 after three years of use (at the end of year
3).The existing machine was purchased two years ago for $90,000
(including installation). It is being
depreciated using a 3 year MACRS recovery schedule. It can be sold today for $20,000. It can be used for three more years, but
after three more years it will have no market value.The earnings before taxes and depreciation (EBITDA) are as
follows:New machine: Year 1: 133,000, Year 2: 96,000, Year 3: 127,000Existing machine: Year 1: 84,000, Year 2: 70,000, Year 3: 74,000Burton
pays 40 percent taxes on ordinary income and capital gains. They expect
a large increase in sales so their Net Working Capital will increase by $20,000.
Calculate
the initial investment required for this projectDetermine
the incremental operating cash flowsFind
the terminal cash flow for the project
Burton
has determined its optimal capital structure, which is composed of the
following sources and target market value proportions.Debt: Burton can
sell a 15-year, $1,000 par value, 8 percent annual coupon bond for $1,050. A
flotation cost of 2 percent of the face (par) value would be required.
Additionally, the firm has a marginal tax rate of 40 percent.Common Stock: Burton’s
common stock is currently selling for $75 per share. The dividend expected to
be paid at the end of the coming year is $5. Its dividend payments have been
growing at a constant 3% rate. It is
expected that to sell all the shares, a new common stock issue must be
underpriced $2 per share and the firm must pay 1% of market value per
share in flotation costs.
Calculate
the after-tax cost of debtCalculate
the cost of equity (for new common stock issues)
Calculate the WACC
Burton
wants to determine if replacing their machine will benefit their shareholders
(see #1). They believe the cash flows
are somewhat uncertain and adjust for risk using a RADR. For the level of risk they will be taking,
they prefer using a RADR of 10%.
Calculate
the NPV and IRR using Burtonâs cost of capital (see #2).Calculate
the NPV and IRR using the RADR.Should
they purchase the new machine? Why or
why not?
Burton has established a target capital structure of 40
percent debt and 60 percent common equity. The firm expects to earn $600 in
after-tax income during the coming year, and it will retain 40 percent of those
earnings. The current market price of the firm’s stock is P0 = $75;
its last dividend was D0 = $4.85, and its expected dividend growth
rate is 3 percent. Burton can issue new common stock at a 15 percent flotation
cost. What will Burton’s marginal cost of equity capital (not the WACC)
be if it must fund a capital budget requiring $600 in total new capital?
