Finance assignment ASPS

FIN311 In-class Assignment #3

Names _______________________________________________________________________________

1. Burton, a manufacturer of snowboards, is considering replacing an existing piece of equipment with a more sophisticated machine. The following information is given.

 The proposed machine will cost $120,000 and have installation costs of $15,000. It will be depreciated using a 3 year MACRS recovery schedule. It can be sold for $60,000 after three years of use (at the end of year 3).

 The existing machine was purchased two years ago for $90,000 (including installation). It is being depreciated using a 3 year MACRS recovery schedule. It can be sold today for $20,000. It can be used for three more years, but after three more years it will have no market value.

 The earnings before taxes and depreciation are as follows: o New machine: Year 1: 133,000, Year 2: 96,000, Year 3: 127,000 o Existing machine: Year 1: 84,000, Year 2: 70,000, Year 3: 74,000

 Burton pays 40 percent taxes on ordinary income and capital gains.

 They expect a large increase in sales so their Net Working Capital will increase by $20,000. a. Calculate the initial investment required for this project. b. Determine the incremental operating cash flows c. Find the terminal cash flow for the project

a. Initial Outlay

New machine: Purchase + Install $135,000

Old machine: Sales price = 20,000 Sales price = $20,000

-Book Value (.22*90k)=19,800

-Taxes = 80

Gain (20k – 19.8k) = 200 After-tax salvage = ($19,920)

Taxes (.4*200) = 80

Working Capital: $20,000 $20,000

Initial Investment 135,000-19,920+20,000 = $135,080

b. Incremental (relevant) Cash Flows

Pre-tax cash

flows Year 1 Year 2 Year 3 Change in cash flows

New 133000 96000 127000 Incremental CF Year 1 Year 2 Year 3

Old 84000 70000 74000

Change in Cash

flow 49000 26000 53000

Change in

Deprec 31050 54450 20250

Deprec New 44550 60750 20250 EBT 17950 -28450 32750

Old 13500 6300 0 Taxes 40% -7180 11380 -13100

Project income 10770 -17070 19650

Add back depr 31050 54450 20250

NI 41820 37380 39900

c. Terminal Cash Flow

New machine: Sales price = 60000 Sales price = 60000

-Book Value (.07*135k)=9,450 - Taxes = 20,220

Gain (60000 – 9,450) = 50,550 After-tax salvage = 39,780

Taxes (.4*50,550) = 20,220

Old machine: Sales price = 0 Sales price = 0

-Book Value (.0*90k)=0 -Taxes = 0

Loss (0 – 0k) = 0 After-tax salvage = 0

Taxes (.4*0) = 0

Working Capital: $20,000 $20,000

Initial Investment 39,780-0+20,000 = $59,780

2. Burton has determined its optimal capital structure, which is composed of the following sources and

target market value proportions.

Debt: Burton can sell a 15-year, $1,000 par value, 8 percent annual coupon bond for $1,050. A flotation cost of 2 percent of the face value would be required. Additionally, the firm has a marginal tax rate of 40 percent. Common Stock: Burton's common stock is currently selling for $75 per share. The dividend expected to be paid at the end of the coming year is $5. Its dividend payments have been growing at a constant 3% rate. It is expected that to sell all the shares, a new common stock issue must be underpriced $2 per share and the firm must pay 1% of market value per share in flotation costs. a. Calculate the after-tax cost of debt. b. Calculate the cost of equity (for new common stock issues). c. Calculate the WACC

a. YTM: N = 15, FV = $1,000, PV = $1,050-20 = $1,030, PMT = $80, I = 7.66%

rd = 7.66(1-.4) = 4.6%

b. re = 5/((75(1-.01)-2) + .03 = 9.92% c. WACC = .6(4.6) + .4(9.92) = 6.73%

3. Burton wants to determine if replacing their machine will benefit their shareholders (see #1). They

believe the cash flows are somewhat uncertain and adjust for risk using a RADR. For the level of risk they will be taking, they prefer using a RADR of 10%. a. Calculate the NPV and IRR using Burton’s cost of capital (see #2). b. Calculate the NPV and IRR using the RADR. c. Should they purchase the new machine? Why or why not?

a. Cash flows (from #1): CF0 = -135,080, C01 = 41,820, C02 = 37,380, C03 = 39,900 + 59,780 = 99,680; I = 6.73% NPV = $18,905.18, IRR = 13.11%

b. Same cash flows from part a, I = 10%

NPV = $8,721.80, IRR = 13.11%

c. Yes, they should purchase the new machine. After adjusting for risk they have a positive NPV and the IRR > RADR.

4. Burton has established a target capital structure of 40 percent debt and 60 percent common equity. The firm expects to earn $600 in after-tax income during the coming year, and it will retain 40 percent of those earnings. The current market price of the firm's stock is P0 = $75; its last dividend was D0 = $4.85, and its expected dividend growth rate is 3 percent. Burton can issue new common stock at a 15 percent flotation cost. What will Burton's marginal cost of equity capital (not the WACC) be if it must fund a capital budget requiring $600 in total new capital? BPRE = (.4 x 600)/.6 = $400 Because Retained Earnings is $240, they can only spend $400 total on capital projects without having to issue new equity. Because their capital budget is $600 they must issue new equity. The cost of new equity should be included in the WACC and is as follows: re = 4.85(1.03) + .03 = .1084 or 10.84% 75(1 - .15)