Question

The Sunrise Bakery Corporation was originally founded in Houston, TX in 1991 by Griffin Harris, who currently serves as the company's Chief Executive Officer. About four years ago, Griffin's daughter, Erica, moved into the company to serve as Chief Financial Officer. Erica had graduated from college a few years ago and had worked for a few years in retail. However, for the past two years, she had been working quite successfully on an online accounting degree, but she still felt a little uncomfortable in her new role as CFO of the family business. Sunrise produces and markets a variety of bakery products throughout southeast Texas and Louisiana. They operate mostly through warehouse delivery and produce fresh breads, buns, rolls, and snack cakes under a few of their own regional brands but also including some licensed "big name" national brands. In total, they operate five bakeries with one very large facility and four smaller production sites. For the past three years, sales have averaged about $15 Million, generating about $650 Thousand in Net Income per year. However, sales have been roughly flat for the past six years as growth has slowed and production capacity has reached nearly 100%. In order to grow sales, Sunrise Bakery needs to invest in further production capacity Griffin Harris has been looking to purchase more space, build additional bakeries, or even perhaps acquire one of their smaller competitors, but nothing specific has worked out yet. Erica has an alternative short-term plan to modernize the production process at their main plant. Her idea involves the purchase of a new, significantly faster, integrated commercial oven that she recently saw displayed at a trade show. Few other bakeries in the region have invested in this modern equipment, and she expects it may cut costs and improve output efficiency. Her sales representative suggests the new oven could raise incremental sales at their large bakery by 15%. Installation of the oven could be mostly executed over the upcoming Labor-day long weekend and shouldn't disrupt sales or production too much. However, the new oven requires an expenditure of $350,000, which would be a large capital expenditure for Sunrise. To reflect the wear and tear on the oven, tax law allows for a 10% annual reduction in the value of the oven as a depreciation expense. That is, Erica's financial forecast includes a non-cash expense of $35,000 for each of the next six years. After six years, Erica's sales representative expects the oven to be worth about $140,000, which is just equal to the accounting book value of the oven after six years of accumulated depreciation ($140,000 = $350,000 6 10%*S350,000) Operation of the oven also requires a small initial investment in an inventory of spare parts of $15,000. The inventory should be fully recoverable for $15,000 if the machine is sold. The investment in inventory represents an increase in other current assets (inventory) that should be included as a change in working capital requirements for Sunrise Bakery. Sunrise estimates receivables at 1.5% of revenues and payables at 2% of revenues each year. At the end of the project, Erica expects to recover all of the working capital invested in the project. In other words, she expects a cash flow equal to the amount of Non-Cash Current Assets less Current Liabilities in the last year of the project. Erica's financial forecast for the new oven does not require any significant change in financing. Sunrise started with one small bakery entirely paid for with cash from Griffin Harris and a mortgage on the bakery property. Currently, Sunrise maintains a rough capital structure of about 25% debt and 75%

Answer 1

1. Cost of debt = pre-tax cost of debt*(1-tax rate)

Pre-tax cost of debt is yield to maturity of the bonds in case debt is bonds issued. here no information has been given about the debt except interest rate and % of debt in capital structure. So we will consider interest rate as Pre-tax cost of debt.

Cost of debt = 4.5%*(1-0.30) = 4.5%*0.70 = 3.15%

2. Cost of equity = Risk-free rate + beta of the stock*market or equity risk premium

Cost of equity = 3% + 0.8*5.5% = 3% + 4.4% = 7.4%

3. WACC = weight of debt*after-tax cost of debt + weight of equity*cost of equity

Weight of debt is 25% and equity 75%.

WACC = 0.25*3.15% + 0.75*7.4% = 0.7875% + 5.55% = 6.34%

4. As the new oven will be purchased with available cash and retained earnings of Sunrise, so cost of equity should be used to evaluate the feasibility of oven purchase. Cost of retained earnings will be cost of equity and no new debt will be used for oven purchase.

If any new debt will be going to use along with retained earnings then WACC will be appropriate to evaluate the feasibility of oven purchase..

5. Annual depreciation expense = cost of equipment*depreciation rate

Annual depreciation expense = $350,000*10% = $35,000