Question

Burke Enterprises is considering a machine costing $30 billion that will result in initial after-tax cash savings of $3.7 billion at the end of the first year, and these savings will grow at a rate of 2 percent per year for 11 years. After 11 years, the company can sell the parts for $5 billion. Burke has a target debt/equity ratio of 1.2, a beta of 1.79. You estimate that the return on the market is 7.5% and T-bills are currently yielding 2.5%. Burke has two issuances of bonds outstanding. The first has 200,000 bonds trading at 98% of par, with coupons of 5%, face of $1000, and maturity of 5 years. The second has 500,000 bonds trading at par, with coupons of 7.5%, face of $1000, and maturity of 12 years. Kate, the CEO, usually applies an adjustment factor to the discount rate of +2 for such highly innovative projects. Should the company take on the project?

Answer 1

Cost of equity = risk free rate + Beta * (market return - risk free rate)

Cost of equity = 2.5% + 1.79 * (7.5% - 2.5%) = 11.45%

Market value of first bond (trading at 98% to par value) = 200,000 *1000 * 98% = $196 million

Second bond is trading at par value = 500,000 * 1000 *100% = $500 million

Coupon on first bond = 5% and coupon on second bond = 7.5%

Cost of total debt = (5% * 196 + 7.5% * 500) / (196 + 500)

Cost of total debt = 6.80%

Debt / Equity = 1.2

% of debt = 1.2 / (1.2 +1) = 54.55%

% of equity = 1 / (1.2 +1 ) = 45.45%

Assuming tax rate of 35%

Weighted average cost of capital = 11.45% * 45.45% + 6.8% * (1-35%) * 54.55%

Weighted average cost of capital = 7.62%

Additional adjustment factor of +2 by the CEO, cost of capital = 7.62% + 2% = 9.62%

Applying the project cash flow NPV is -$1.4 billion, hence project should not be accepted

Year	Cash flow	Discount rate at 9.62%	Present value of cash flow
0	-30.0	1.000	-30.0
1	3.7	0.912	3.4
2	3.8	0.832	3.1
3	3.8	0.759	2.9
4	3.9	0.693	2.7
5	4.0	0.632	2.5
6	4.1	0.576	2.4
7	4.2	0.526	2.2
8	4.3	0.480	2.0
9	4.3	0.438	1.9
10	4.4	0.399	1.8
11	9.5	0.364	3.5
		NPV	-1.6

Excel formula:

A B 1 Year Cash flow Discount rate at 9.62% Present value of cash flow 1/(1+9.62%)^A2 1/(1+9.62%)^A3 1/(1+9.62%)^A4 1/(1+9.62 %)^A5 =1/(1+9.62%)^A6 1/(1+9.62%)^A7 =1/(1+9.62%)^A8 =1/(1+9.62%)^A9 =1/(1+9.62%)^A10 1/(1+9.62%)^A11 1/(1+9.62%)^A12 13 A12+1 B12*1.02+5 1/(1+9.62%)^A13 B2*C2 2 0 -30 B3*C3 3 A2+1 3.7 4 A3+1B3*1.02 5 A4+1=B4*1.02 B4*C4 =B5*C5 6+A5+1B5*1.02 -B6*C6 7 A6+1B6*1.02 B7*C7 8A7+1 B7*1.02 B8*C8 9A8+1B8*1.02 B9*C9 10 A9+1B9*1.02 B10*C10 B11 C11 11 +A10+1 B10*1.02 12A11+1 -B11*1.02 B12 C12 =B13 C13 =SUM(D2:D13) 14 NPV