Question 1: You have been asked by Wavejumper (WJ) Ltd., a manufacturer of windsurfers, to evaluate its capital structure. As a first step, you need to estimate WJ's current weighted average cost of capital (WACC). You have been provided with the following information to complete this task.
WJ currently has a $200 million face value long-term debt issue outstanding. The bonds have 6 years remaining until maturity, carry a 12% coupon, payable semi-annually, and are priced to yield 10%. WJ also has 10 million preferred shares outstanding. These shares have a stated par value of $25, carry a 6% dividend rate, and are currently trading at $18.75. Finally, WJ has 15 million common shares outstanding, which are currently trading at $21. WJ paid a dividend of $1.25 per share on its common shares last year and investment analysts have projected these dividends to grow at an average annual rate of 3% for the foreseeable future.
WJ has been advised by its underwriters that flotation costs would be 4% after-tax on new debt and preferred shares, and 6% before-tax on common shares. WJ's marginal tax rate is 38%.
Required
- Determine the appropriate weights to use in determining WJ's WACC.
- Calculate WJ's cost of debt, cost of preferred shares, cost of internal equity, and cost of issuing new common equity.
- Based on your calculations in parts (a) and (b), estimate the firm's WACC, assuming all of the required equity can be generated internally.
- What is the firm's marginal cost of capital (MCC) if the firm needs to issue new common shares?
Question 2:
Stewiacke Ltd. is currently considering a project with a 4-year life that it believes has the potential to return the company to profitability. Having completed a market survey at the cost of $50,000, it is now ready to undertake a capital budgeting analysis of the project. The following information has been collected for the purpose of determining the project's net present value (NPV).
The project will require an initial investment of $8 million that will be split equally between a new building and new equipment. The project will also require an investment of $500,000 in additional net working capital that will be released at the conclusion of the project.
Stewiacke intends to build on a block of land that it purchased last year for $2 million. The land has a current market value of $2.5 million and independent appraisers have indicated that its value should grow at an average annual rate of 3% over the next 10 years. The equipment is estimated to have a 4-year useful life, at the end of which it is expected to have a zero salvage value. The building is estimated to have a 15-year useful life, with an expected salvage value at the end equal to 25% of its original cost. At the end of year 4, the building is expected to be worth 50% of its original cost. Both the building and equipment will be depreciated on a straight-line basis for accounting purposes.
It is estimated that the project will generate gross revenues of $6 million per year, with costs of goods sold expected to be 55% of gross revenues.
Finally, Stewiacke's marginal tax rate is 30% and its weighted average cost of capital is 10%. The applicable CCA rates on the new building and the new equipment are 15% and 7.5%, respectively.
Required
- Estimate the initial after-tax cash outlay for the proposed project.
- Estimate the net present value associated with the proposed project.
- Should Stewiacke Ltd. go ahead with this project? Briefly explain.
- Given that Stewiacke presently has 10 million common shares outstanding that are trading at $10.00 per share, what will be the new price per share if the firm accepts this project, assuming the markets are efficient?
Question 3:
a) After calculating a positive NPV of 11,911, Renew Inc. has decided to undertake a three-year project to manufacture guardrails from recycled plastic. The project requires a $150,000 machine that will be amortized over three years on a straight-line basis for accounting purposes to an estimated salvage value of $25,000 at the end of the project. Renew is now trying to decide whether to lease the machine or to purchase it.
Additional information used in the NPV calculation is as follows. The project will require an additional investment in inventory of $20,000 and is expected to generate net (before-tax) operating cash flows of $80,000, 90,000, 100,000 in years 1 through 3, respectively. . Renews tax rate is 36%, its weighted average cost of capital is 21%, and the applicable CCA rate on the machine is 20%.
If Renew decides to lease the machine, it will have to make annual lease payments of $40,000 per year at the beginning of the year.
Determine whether Renew should lease or purchase the machine if its before-tax cost of borrowing is 8%.
b) Briefly describe three motivations for leasing.
Question 4:
BMP Consulting (BMPC) conducted an analysis of Delta Corp. and found that the firm consists of two different divisions: Pet Lovers, a pet supply retail outlet, and Able Move, a long-distance moving company. Delta is currently considering a project related to pet supplies and has asked for BMPC's assistance with the analysis. As a part of its response, BMPC examined firms that operate within the industries of each of Delta's two divisions, finding the following:
Firm Industry Cost of capital
Not Just Dogs Pet supply 8%
Canines and Felines Pet supply 10%
Reliable Movers Long-distance moving 14%
TransCanada Movers Long distance moving 18%
a) When is it appropriate to use the firm's weighted average cost of capital (WACC) to evaluate a proposed investment?
b) Based on this information, what is a reasonable discount rate for BMPC to use in its assessment of the proposed pet supply project? Describe any assumptions that you make in arriving at this discount rate.
c) What would be the potential implications for Delta if WACC is used to evaluate the pet supply project?