You must evaluate a proposal to buy a machine. The cost of the machine is 30,000

Question

You must evaluate a proposal to buy a machine. The cost of the machine is 30,000 and shipping, modification and installation would cost an additional 15,000. Purchase of the machine would require a $10,000 increase in net operating working capital which is expected to be fully recovered at the end of the project's life. The machine will be depreciated using MACRS 3-year class life (33%, 45%, 15%, 7%) and it would be sold after 3 years for $3,500. Revenues are expected to increase by 25,000 per year; however, labor costs are also expected to increase by 5,000 per year. The marginal tax rate is 40%. The firm has 20 year bonds outstanding selling for $900. The coupon rate on the bonds is 5% and the bonds pay interest annually. The beta of the firm's common stock is 1.0. Risk-free rate is 5% and market risk premium is 5%. The target capital structure is 40% debt and 60% common equity. What is the firm's WACC?

Explanation / Answer

WACC = wd x kd x (1 - tax) + we x ke

Here, wd - weight of debt = 40%, we - weight of equity = 60%, kd - cost of debt, ke - cost of equity

Using CAPM, Cost of equity, ke = Rf + beta x MRP = 5% + 1 x 5% = 10%

Cost of debt can be calculated using I/Y function

N = 20, PV = -900, FV = 1000, PMT = 5% x 1000 = 50 => Compute I/Y = 5.86% = kd

WACC = 40% x 5.86% x (1 - 40%) + 60% x 10% = 7.41%

Machine 0 1 2 3 4 MACRS 33% 45% 15% 7% Investment -45,000 3150 NWC -10,000 10,000 Salvage 3,500 Savings 20,000 20,000 20,000 Depreciation -14850 -20250 -6750 EBT 5,150 -250 13,250 Tax (40%) -2060 100 -5300 Profits 3,090 -150 7,950 Cash Flows -55,000 17,940 20,100 28,060 NPV $1,772.16

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