Question

Help with a) and b)

GlaxoSmithKline plc is a pharmaceutical 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 pa. over the next 6 years. The corporate tax rate is 35%. The new machine has average risk. GlaxoSmithKline's debt-equity ratio is 0.5 and it plans to cost of equity is 13.10% a) Compute GlaxoSmithKline's weighted average cost of capital. b) What is the NPV of the new machine and should GlaxoSmithKline replace the old machine with the new one?

Answer 1

a) Weight of equity, we = 1 / (1 + D/E) = 1 / (1 + 0.5) = 67%, weight of debt, wd = 33%

=> WACC = wd x rd x (1 - tax) + we x re = 33% x 13.1% x (1 - 35%) + 67% x 13.10% = 10.00%

b) PV of cash flows of the new machine can be calculated using PV function

N = 6, PMT = 11,416.55, I/Y = 10%, FV = 0

=> Compute PV = $49,722.05

=> NPV = 49,722.05 - 50,000 + 8,000 = $7,722.05