3. Simms Enterprises is attempting to evaluate the possibility of investing $85,

Question

3. Simms Enterprises is attempting to evaluate the possibility of investing $85,000 in a machine having a 5-year life. The firm has estimated the cash inflows associated with the proposal as shown below. Simms has a capital structure containing 40% debt, 20% preferred stock, and 40% common stock. The firm’s outstanding bonds have an $80 annual coupon, a par-value of $1,000, 10 years left to maturity, and a current price of $1,250. The firm’s annual preferred stock dividend is $4.00 and their preferred shares are currently selling for $20. The firm’s common stock has a beta of 1.3. The risk-free rate is 3% and the required return on the market is 9%. The firm faces a tax rate of 40%.

CF1 $18,000 CF2 $22,500 CF3 $27,000 CF4 $31,500 CF5 $36,000

a. What is the firm’s wacc? b. What is the project’s payback? c. What is the project’s discounted payback? d. What is the projects net present value? e. What is the internal rate of return on this investment? f. What is the project’s modified internal rate of return? g. Should you accept this project? Why?

Explanation / Answer

The firm has purchased machinery worth = $85,000 Firms capital structure: Debt 40% Preferred stock 20% Common stock 40% Now we have to calculate the cost of these sources of finance to get WACC. For Cost of equity: Risk free rate = 3% beta= 1.3 required rate of return = 9% Therefore cost of equity = 3% + (9% - 3%)x1.3 = 10.800% For cost of Preferred Stock: Stock dividend = $4 Currenr price = $20 Therefore cost of Preferred stock = 20.00% For cost of Preferred Stock: Stock dividend = $4 Currenr price = $20 Therefore cost of Preferred stock = 20.00% For cost of debt: face value = $1,000 Currenr price = $1,250 Time = 10 years Coupon = $80 Therefore cost of debt= 1.22% Tax Rate = 40% Answer-a Therefore WACC = 8.613% Answer-b Years Cash Flows Cumulative cash flows 0 -85000 1 18000 18000 2 22500 40500 3 27000 67500 4 31500 99000 5 36000 135000 Cash to be recovered = $85,000 Cash of $67500 is recovered in 3 years Remaining amount to be recovered = $85000 -$67500 = $17,500 Now, $99000 is recovered in = 12 months $17500 will be recovered in = 2.121212121 months So payback period = 3 years and 2.1212 months Answer-c Discount Rate = 8.613% Years Cash Flows PV of cash flows Cumulative cash flows 0 -85000 -85000 1 18000 $16,572.55 $16,572.55 2 22500 $19,072.88 $35,645.43 3 27000 $21,072.42 $56,717.85 4 31500 $22,634.87 $79,352.71 5 36000 $23,816.99 $103,169.70 Cash to be recovered = $85,000 Cash of $79352.71 is recovered in 4 years Remaining amount to be recovered = $85000 -$79352.71 = $5,647 Now, $103169.70 is recovered in = 12 months $5647 will be recovered in = 0.656853985 months So Discounted payback period = 4 years and 0.657 months Answer-d Years Cash Flows 0 -85000 1 18000 2 22500 3 27000 4 31500 5 36000 Projects NPV at 8.613% = $18,170.70 Answer-d Projects IRR = 15.58% Answer-e Modified IRR = {(FV of positive cash flows)/(PV of negative cash flows)}^1/n - 1 Years Cash Flows Present value Future value 0 -85000 $85,000.00 1 18000 $25,049.54 2 22500 $28,828.89 3 27000 $31,851.32 4 31500 $34,213.10 5 36000 $36,000.00 Total = $85,000.00 $155,942.84 Modified IRR = 12.90% Here IRR, MIRR are greated than the cost of capital which is 8.613%. Also the NPV of the project is positive. So the project should be accepted.

Related Questions

Navigate

• Browse (All)
• Browse 3
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.