Question

Reckitt Benckiser Group plc is a British consumer goods company. It is considering the replacement of one of its existing machines with a new model. The existing machine can be sold now for £8,000. The new machine costs £50,000 and will generate free cash flows of £11,416.55 p.a. over the next 6 years. The corporate tax rate is 35%. The new machine has average risk. Reckitt Benckiser's debt-equity ratio is 0.5 and it plans to maintain a constant debt-equity ratio. Reckitt Benckiser's before- tax cost of debt is 5.85% and its cost of equity is 13.10%. a) Compute Reckitt Benckiser's weighted average cost of capital. (5 marks) b) What is the NPV of the new machine and should Reckitt Benckiser replace the old machine with the new one? (10 marks) c) The average debt-to-value ratio in the pharmaceutical industry is 20%. What would Reckitt Benckiser's cost of equity be if it took on the average amount of debt of its industry at a cost of debt of 5%? Do this calculation assuming the company does not pay taxes. (10 marks) d) Given the capital structure change in question c), Modigliani and Miller would argue that according to their theory. Reckitt Benckiser's WACC should decline because its cost of equity capital has declined. Discuss. (10 marks) (TOTAL 35 marks)

Need urgent help with b and c, thank you

Answer 1

Debt/equity ratio = 0.5

Debt = 1/3 & equity = 2/3

(a) WACC = Debt*(Cost of debt)*(1-tax)+Equity*(Cost of equity)

WACC = (1/3)*5.85%*(1-35%)+(2/3)*13.10% = 10.00%

(b) Cost of new machine = 50000

Selling price of old machine = 8000

Net cost of new machine = 50000-8000 = 42000

Free cash flow each year = 11416.55

NPV of the project = -42000+11416.55/(1+10%)+11416.55/(1+10%)^2+.....+11416.55/(1+10%)^6

NPV = -42000+(11416.55/10%)*(1-1/(1+10%)^6) = 7722.05

(c) Debt = 20% & equity = 80%

Ke: cost of equity

20%*5%+80%*Ke = (1/3)*5.85%+(2/3)*13.10% = 10.68%

Ke = 12.10%