Journal of the International Academy for Case Studies, Volume 16, Number 5, 2010 Weighted Average Cost of Capital (WACC) Using input from an investment banking firm, Clarkson estimates the company's cost of equity to be 18%.
Their bank has indicated a long-term bank loan can be arranged to finance the new equipment at an annual interest rate of 12% (before tax cost of debt). The bank would require the loan to be secured with the new equipment.
The loan agreement would also include a number of restrictive covenants, including a limitation of dividends while the loans are outstanding. While long-term debt is not included in the firm's current capital structure, Clarkson believes a 30% debt, 70% equity capital mix would be appropriate for Cape Chemical.
Last year, the company's federal-plus-state income tax rate was 30%. Clarkson does not expect the income tax rate to change in the foreseeable future. Used Equipment The used equipment will cost $105,000 with another $15,000 required to install the equipment.
The equipment is projected to have an economic life of three years with a salvage value of $9,000. The equipment will provide the capacity to blend an additional 800,000 gallons annually.
The variable blending cost is estimated to be $.20 per gallon. The equipment will be depreciated under the Modified Accelerate Cost Recovery System (MACRS) 3-year class. Under the current tax law, the depreciation allowances are 0.33, 0.45, 0.15, and 0.07 in years 1 through 4, respectively. The increased sales volume will require an additional investment in working capital of 2% of sales (to be on hand at the beginning of the year).
New Equipment
The acquisition of new equipment with the capacity to blend 1,600,000 gallons annually is the second alternative. The new equipment would cost $360,000 to acquire with an installation cost of $60,000 and have an economic life of seven years and a salvage value of $60,000. The new equipment can be operated more efficiently than the used equipment. The cost to blend a gallon of material is estimated to be $.17. The equipment will be depreciated under the MACRS 7-year class. Under the current tax law, the depreciation allowances are 0.14, 0.25, 0.17, 0.13, 0.09, 0.09, 0.09 and 0.04 in years 1 through 8, respectively. The increased sales volume will require an additional investment in working capital of 2% of sales (to be on hand at the beginning of the year).
REQUIREMENTS
Assume the role of a consultant, and assist Clarkson to answer the following questions.
137 Journal of the International Academy for Case Studies, Volume 16, Number 5, 2010
1. Calculate Cape Chemical's weighted average cost of capital (WACC). Note: round to the nearest whole number. Discuss the theory used by Clarkson to determine Cape Chemical's optimum target capital structure (30% debt and 70% equity).
2. Since the used equipment will be financed with internal capital and the new equipment with a bank loan, should the same discount rate be used to evaluate each alternative? Explain.
3. Explain why an accurate WACC is important to a firm's long-term success.
4. Evaluate the strengths and weaknesses of the Cash Payback Period, Discounted Cash Payback Period, NPV, IRR and MIRR capital expenditure budgeting methods. Prepare a recommendation for Stewart regarding the capital budgeting method or methods to use in evaluating the expansion alternatives. Support your answer.
5. Calculate the Cash Payback Period, Discounted Cash Payback Period, NPV, IRR and MIRR for each alternative. For the calculations, assume a WACC of 15%. Based on the results of these methods, should either option be selected? Why? Solution requires preparation of a spreadsheet.
6. Stewart is concerned that the projected annual sales growth rate of 15% for incremental blended material may be optimistic. Recalculate the Cash Payback Period, Discounted Cash Payback Period, NPV, IRR and MIRR for each alternative assuming the annual sales growth rates of 10% and 5%. Assume a WACC of 15%. Does the change in growth rate alter the recommendation made in question 5? Solution requires preparation of spreadsheets. Explain.
7. The projected cash flow benefits of both projects did not include the effects of inflation. Future cash flows were determined using a constant selling price and operating costs (real cash flows).
The cash flows were then discounted using a WACC that included the impact of inflation (nominal WACC). Discuss the problem with using real cash flows and a nominal WACC when calculating a project's Discounted Payback Period, NPV, IRR and MIRR.
8. What other issues should Stewart and Clarkson considered before a final decision regarding the expansion alternatives is made?