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Capital Budgeting and WACC

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Question 1 (25 Points)

Zinn Corp. has 3.50 million shares of common stock outstanding.  The firm is in steady-state growth, and analysts expect the firm’s earnings and dividends to continue to grow at their historical rate for the foreseeable future—per share dividends on common have grown from $2.00 six years ago to $2.90 today.  Each share of Zinn’s common stock is selling for $38.50 today.  The firm’s beta is estimated to be 1.85.  The long-term Treasury rate is 3.75%, and the expected market risk premium is 6.5%.  Analysts estimate that potential equity investors will require a premium of 5.5% over the firm’s bond yield.

The firm’s long-term debt consists of 6.25% coupon bonds, which were issued 8 years ago with an original maturity of 20 years.  These bonds pay interest annually.  Today, these bonds have a yield of 9.75%.  The book value of these bonds is $350 million. Zinn Corp. also has 480,000 shares of perpetual preferred stock outstanding, and these pay a fixed dividend of $7 per year on a face value of $50.  Each share of the firm’s preferred currently sells for $79. The firm’s marginal tax rate is 30%.  Estimate the firm’s weighted average cost of capital (WACC).

 

Make sure to show all work clearly.  As you set up your table in Excel, please use the order of columns and rows as shown below

 

Source # Securities Price Mkt Value Weight Pre-Tax Cost Post-Tax Cost Wtd Post-Tax
Debt
Preferred
Common

 

                                                                                                                                                      Sum WACC=

Question 2 (20 Points)

Better-Rock & Co. is bidding on a contract to supply 85,000 units per year for 3 years of a special type of geophone used in oil exploration.  The equipment required to produce these geophones has an installed cost of $4.2 million.  An estimated $200,000 will have to be invested initially in net working capital (to be recovered at project end).  The equipment will be depreciated on a straight-line basis on a 5-year schedule, and sold at the end of 3 years for an estimated $2.2 million.

Annual fixed operating costs (other than depreciation) are expected to be $320,000.  Variable operating costs should amount to 30% of sales revenue.  Better-Rock & Co. has a required return of 12% on this project.  Its marginal tax rate is 35%.  What per-unit price should Better-Rock bid at a minimum?

Question 3 (15 Points)

Clementi Corp.  has debt in the form of 8.00% coupon bonds that have 14 years remaining until maturity.  These bonds pay interest semiannually, and have a yield of 4.25% at the present time.  The book value of these bonds is $125 million.  The company’s common stock is currently trading at 88.90 per share.  There are 2.25 million shares of Clementi stock outstanding.  The firm has no preferred stock.  There is insufficient price history for Clementi stock to allow you to estimate the company’s equity beta, so you turn to a comparable firm that has sufficient data.

You use regression analysis to estimate the beta for this comparable firm.  Your results suggest a beta of 1.30.  In market value terms, the comparable firm has a $298 million of debt and $480 million of equity.  Both Clementi Corp. and the comparable firm face a 35% marginal tax rate.

  1. Estimate the equity beta for Clementi Corp.
  2. If the risk-free rate is 2.80% and the market risk premium is 6.25%, estimate the required rate of return on Clementi stock.

Question 4 (20 points)

Praeda Inc. has the choice of buying a piece of equipment or leasing it.  The purchase cost of the equipment will be $155,000.  For tax purposes, the depreciation on the machine will be full, straight-line depreciation over 7 years.  The machine will be used for 5 years, regardless of whether it is purchased or leased.  The machine is expected to have a market value of $70,250 at the end of the 5 years.  The lessor will require annual payments of $21,000.  A total of 5 annual payments will be required under the lease contract, with the first payment due immediately (that is, at the start of the first year).  The lease will be treated as an operating lease for tax and reporting purposes.

Praeda Inc. pays 6.25% interest on its loans, and its weighted average cost of capital is 8.75%.  The company faces a marginal tax rate of 21%.

  1. What is the cost of leasing?
  2. What is the cost of borrowing?
  3. Should Praeda Inc. lease the machine, or should it buy the machine? You must explain your answer in order to get any credit.

(You MUST use the lease-minus-buy approach to answer this question.  Make sure to explain your buy/lease decision; don’t limit your answer to just a calculation.) Question 5 (20 points)

A company is evaluating a machine for possible purchase.  The estimated price of the machine is $400,000 and an additional $50,000 will be needed for shipping, installing, and getting the machine ready for use.  The machine will be depreciated according to the 5-year MACRS class though the company plans to use it for only 3 years. The depreciation rates by year are provided below.  The estimated selling price of the machine after the 3 years is $250,000.

If purchased, this machine will necessitate an initial increase in net working capital of $30,000 which is expected to be recovered when the machine is sold.  The firm estimates that the acquisition of this machine will boost overall revenue by $145,000 for each year.  The new machine is expected to increase operating costs (other than depreciation) by $22,000 for each year.  The company’s applicable tax rate is 21%.  The firm’s cost of capital is 8%.  Estimate the NPV & IRR of this machine, and comment on whether or not the company should invest in it.

MACRS Depreciation Rates for the 5-year Class:-

Year       Dep. %

1             20

2             32

3             19.20

4             11.52

5             11.52

6             5.76