Blue Bottling, Inc. (BBI), is a bottling company and is considering expanding in

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.

About the Machine
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%.

Requirements of the Assignment

Using Excel, 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

1) INITIAL INVESTMENT: cost of the new machine 260000 cost of modification 40000 total cost of the new machine 300000 increase in net working capital 5000 Total initial investment 305000 2) OPERATING CASH FLOWS: Annual EBITDA 60000 depreciation (300000-30500)/7 38500 EBT 21500 tax @ 40% 8600 EAT 12900 add: depreciation 38500 Annual operating cash flows 51400 3) TERMINAL CASH FLOWS: salvage value of the machine 38500 recovery of net working capital 5000 Total terminal cash flows 43500 4) WACC: Cost of debt - Kd: To be found out by solving for 'r' from the following equation: 1048 = 1000*pvif(r,36) + 25*0.6*pvifa(r,36) To be done by trial and error. discounting with 2% (semi annual rate) pv = 1000*0.4902 + 15*25.4888 = 490.2 + 382.33 = 572.53 discount with 1% (semi annual rate) pv= 1000*0.6989 + 15*30.1075 = 698.9 + 451.61 = 1150.51 exacat rate = 1 + 102.51/577.98 = 1.17735% Annual rate = 1.17735*2 = 2.35% Therefore after tax Kd = 2.35% Cost of Equity-Ke: a) as per dividend growth model: 3/50 + 0.035 = 0.095 = 9.5% b) as per CAPM: 2.5 + 0.8(10-2.5) = 8.5% c) Average cost of equity = (9.5+8.5)/2 = 9% # shares unit Total specific Now, WACC bonds MV MV weight cost WACC equity 100000 50 5000000 0.4053 9.00 3.65 debt 7000 1048 7336000 0.5947 2.35 1.40 12336000 5.05 5) NPV: PV of operating cash flows = 51400*pvifa(5.05,7) = 51400*5.7759 = 296881 PV of terminal cash flow = 43500*pvif(5.05,7) = 43500*0.7083 = 30811 Total PV of cash inflows 327692 Less: initial cash outflow 305000 NPV 22692 6) DECISION: AS the NPV is positive, the project can be accepted.

Related Questions

Navigate

• Browse (All)
• Browse B
• Subjects

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