Question

Focus Inc. is considering the acquisition of a new piece of equipment. The machine's price is $750.000. In addition, installation and transportation costs would be $60.000 and it would require $15,000 in spare parts thus increasing the firm's net working capital by that amount. The system falls into the MACRS 3-year class (depreciation rates of 33%, 45%, 15%, and 7%). The current machine it would replace could be sold for $85,000 and currently is being earried on the books for $20,000. That amount is scheduled to be depreciated for tax purposes in the next year if the new machine is not purchased. It is estimated that the new equipment would increase productivity and thus increase the firm's before-tax revenues by $175,000 per year and would also reduce its operating costs by $20,000 per year because its greater speed and efficiency. The equipment is expected to be used for 6 years and then be sold for $45,000. The firm's marginal tax rate is 26%. Focus is currently financed in the following fashion: Debt: 55,000 bonds outstanding ($1,000 face or par value) with an 8% coupon, 12 years to maturity, selling for 106 percent of par; the bonds make semiannual payments. Common Stock: 500,000 shares outstanding, selling for $65 per share; the beta is 1.2. Preferred Stock: 70,000 shares outstanding ($100 par value), it pays a 10% dividend on par, and it is selling for $110 per share. Market: The market risk premium is 9% and the risk-free rate is 2%. a. Calculate the firm's current capital structure (wd, we, wps): b. Calculate the firm's before-tax cost of debt financing: c. Calculate the firm's cost of equity financing: d. Calculate the firm's cost of preferred stock financing: e. Calculate the firm's WACC f. What is the initial outlay for the project? g. Calculate the change in depreciation for each year. h. Calculate the operating cash flows for each year. i. What is the salvage value for the project? j. Summarize the net cash flows for each year beginning with the initial outlay. k. Calculate the project's NPV and IRR. 1. Explain why the firm should either accept or reject this project.

Answer 1

1. Firms current capital structure is as follow:

		Amount	Weight ( amount/total)
Debt	55000*1000	$       55,000,000	0.58
Stock	500000*65	$       32,500,000	0.34
preferred stock	70000*110	$          7,700,000	0.08
	Total	$       95,200,000	1.00

Here the weights are calculated on the basis of market values

2. Before tax cost of debt:

Cost of Bond

YTM= (C+ (F-P)/n)/(F+P/2)

C= coupon amount= 1000*0.08= 80

F= face value=1000

P= Price= 1000*106%= 1060

N= tenor= 12

YTM= (80+(1000-1060)/12)/(1000+1060)/2

YTM=70/1030

YTM= 0.0728 or 7.28%

3. Cost of equity:

Cost of new equity= R(f)+ β{E(m)-R(f)}

·                      R(f) = Risk-Free Rate of Return= 2%

·                      [E(m)-R(f)] = equity risk premium= 9%

beta =1.2

Cost of equity = 2+ 1.2*9%

=0.02+0.108

0.128

or 12.80%

4. Cost of preferred stock:

preferred stock"
cost of PS=	Dividend per share/ current market price
Par value=	100
Dividend rate	10%
Dividend =	100*10%= 10
Cost=	10/110
	0.0909
	9.09 %

5. From all the calculated data

Particulars	Cost	tax	After tax cost	weights= market value / total	after tax cost * weights
Bonds	7.28%	26%	=0.0728*(1-0.26)= 0.0539 or 5.39%	0.58	0.0539*0.58	0.0311
Preferred Stock	9.09%	0%	9.09%	0.08	0.0909*.08	0.0074
Equity	12.80%	0%	12.80%	0.34	0.1280*.34	0.0437
			total			0.0822

So WACC= 8.22%