pial Budgeting Per the machil is considering S165 million upgrade of its machine
ID: 2799145 • Letter: P
Question
pial Budgeting Per the machil is considering S165 million upgrade of its machinery. Once the plant is upgraded, tlows: S2s will last for 30 years. The upgrade is expected to generate the following net cash Secondoanually in the tirst decade after the investment: $20 million annually in the investmen the investment, and $15 million annually in the last decade of the parts) for a t the end of the 30' year, the firm also anticipates that it can sell the equipment (as a total salvage value of SI million. re committing to this investment, the company asked you, their Business Consultant, to ssist capital budgeting project given the various sources of funding available to therm. you, the firm gathered the following data: . The thc fin's corporate tax rate is curenty 40 percent. The tas rate is not expected to change throughout the life of the project. of e company can issue 30-year bonds with a 12% coupon, paid semi annually, and par value 0 ,000 for $1,153.72. Thebond's flotation costswould be 1% of the par value. . T current price of the firm's 10 percent, S100 par value, preferred stock is $113.10. If the firm iss ues new preferred stock, the firm will have to maintain the preferred stock dividend rate constant, and pay $2 in flotation costs per each new preferred share issued. . The firm's common stock is currently selling for $50 per share. Its last dividend (Do) was o If the firm issues new common stock, the net proceels per share are estimated to be 15 . Sap's beta is 1.2. The yield on a 30-year US Treasury Bond is 7 percent per year, and the $4.19 per share. Common stock dividends are expected to grow at a constant rate of5 percent per year in the foreseeable future. percent less than the current price of common share. S&P;'s rate of return is currently 13 percent per year. The firm's target capita! structure is 30 percent long-term debt, 10 percent preferred stock, and 60 percent common stock equity Given this information, the firm asked you to answer the following questions and provide supporting evidence (formulas, calculations, etc) behind your evaluations.Explanation / Answer
AS per data given risk free rate i.e yield on Treasury bond is 7% beta is 1.2 and market return is 13%
Cost of Equity as per above formula is
= 7% + 1.2*(13%-7%)
= 14.2%
For bond par value $ 1000 with flotation cost 1%. 1153.72 market value, 12% semi annual coupon and 30 years to maturity. This results in YTM of 10.33%
After tax cost of Debt = YTM(1-tax rate)= 10.33(1-0.40)= 6.198%
Proposed cost of capital = weight of Common Equity * cost of Equity + weight of preferred stock * cost of preferred stock + weight of Debt * after tax cost of Debt
= 0.60*14.2%+0.10*10.20%+0.30*6.198%
= 11.40%
Firm should use This cost of capital for evaluating proposed Project. As this cost is based on proposed or target weight of different sources of capital through which fund is proposing to raise funds for upcoming project.
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