- 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 (EBITDA) are as follows:
- New machine: Year 1: 133,000, Year 2: 96,000, Year 3: 127,000
- 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.
- Calculate the initial investment required for this project
- Determine the incremental operating cash flows
- Find the terminal cash flow for the project
- 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 (par) 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.
- Calculate the after-tax cost of debt
- Calculate the cost of equity (for new common stock issues)
Calculate the WACC
- 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%.
- Calculate the NPV and IRR using Burton’s cost of capital (see #2).
- Calculate the NPV and IRR using the RADR.
- Should they purchase the new machine? Why or why not?
- 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?