Blue Bottling, Inc. (BBI), is a bottling company and is considering expanding in
ID: 2716185 • Letter: B
Question
Blue Bottling, Inc. (BBI), is a bottling company and is considering expanding into filling 16-ounce bottles. In order to do so, BBI must purchase a new bottling machine. The machine would not replace the machine used to fill 32-ounce bottles. The risk of this project is similar to the current risk of the company. BBI uses Net Present Value as its investment decision method. Therefore, BBI executives have decided that their weighted average cost of capital would be an appropriate discount rate to use when analyzing the project. BBI managers estimate the cost of the machine to be $260,000. In order for the machine to be usable for BBI, it must be modified, costing $40,000. The machine will be depreciated using straight-line depreciation, assuming a 7-year life and $30,500 salvage value. BBI managers believe that the machine will be replaced at the end of 7 years at which time it will be sold for its salvage value. During the 7 years of its use, managers estimate annual earnings before interest, depreciation and taxes (EBITDA) to be $60,000. There will be an increase in net working capital of $5000 with the new press, due to increased accounts receivable and inventory costs. Weighted Average Cost of Capital Current investigation shows that the firm has a 40% marginal tax rate. (Round all numbers to one-hundredth of one percent). Debt The firm has 7000 of its $1000 par, 18-year, 5% semi-annual bonds that are currently outstanding and being quoted at 104:8. Common Stock BBI common stock is currently trading for $50 per share and there are 100,000 shares issued and outstanding. There are two methods of computing the cost of capital, and you should average the two values for your final cost of common stock. The firm will pay annual dividends of $3.00 per share in the coming year. The firm’s dividends and earnings have been growing at an annual rate of 3.5%, and this is expected to continue in the future. Lang’s beta is currently .8 and the current 90-day t-bill rate is 2.5%, while the historic market average is 10%. 1. create a spreadsheet that calculates all relevant cash flows (i.e., initial investment, periodic cash flows, and terminal value). Note: The spreadsheet should have data at the top and the cash flow calculations completely in equations, or picking up numbers from a previous cell. The instructor should be able to change inputs. The spreadsheet automatically adjusts to those changes. Round all numbers to the nearest dollar.
Explanation / Answer
Computation of Weighted Average Cost of Capital (WACC)
Cost of Equity:
Cost of Equity Based on dividend yield:
Given data,
Dividend per share, DPS = $3
Growth Rate, g = 3.5% = 0.035
Market price, P = $50
Applying Formula,
P = DPS / (ke - g)
50 = 3 / (ke – 0.035)
50 ke – 1.75 = 3
50 ke = 4.75
ke = 9.5 %
Cost of Equity as per CAPM:
Given data,
Beta = 0.8
T bill Rate, Rf = 2.5 %
Market rate, Rm = 10%
Applying Formula,
ke = Rf + (Rm-Rf) * beta
ke = 2.5 + (10 – 2.5) * 0.8
ke = 2.5 + 6
ke = 8.5 %
As per the clause given in the problem, cost of equity should be taken as the average of the rates determined under the above two methods.
Therefore, cost of equity = (9.5 + 8.5) / 2 = 9%
Cost of debt:
Given data,
Bond is a 5% semi annual bond
Interest for half year = 5%
Interest p.a, i = 5 * 2 = 10%
Number of conversions = 2
Applying formula,
Effective rate of interest p.a , Kd = (1+i/n)n – 1
Kd = (1+0.1/2)2 – 1
Kd = 1.1025 – 1
Kd = 0.1025
Cost of debt = 10.25 %
WACC:
Given data,
Number of bonds = 7000
Market Price per bond = 1048
Number of shares = 100000
Market Price per share = $50
Market value of bonds, D = 7000 * 1048 = $7336000
Market value of shares, E = 100000 * 50 = $500000
Total Value, V =7336000 + 500000 = $7836000
WACC = (Ke * E/V) +(kd * D/V)
WACC = (9 * 500000/7836000) + (10.25 * 7336000/7836000)
WACC = 0.5743 + 9.5959
WACC = 10.1702%
Computation of Depreciation p.a.:
Spreadsheet showing all cash flows:
Cost 300000 Salvage value 30500 Depreciable value 269500 Useful life 7 Depreciation p.a. 38500Related Questions
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