ABC Mining is reviewing purchase of a new machine. Their information is listed b
ID: 2711144 • Letter: A
Question
ABC Mining is reviewing purchase of a new machine. Their information is listed below.
Capital structure: 50% debt, 50% equity. Tax 40%
Bond - 15 years to maturity, net selling price $1152, 12% coupon, $1000 par
Common stock – current selling price $50, current dividend D0 $4.20
Growth (constant) 5% Beta 1.2 Rrf 7% rm (market return) 12%
What is their after tax cost of capital (rd) for the bond?
What is their cost of capital for equity (rs) using CAPM?
What is their WACC?
..continued… The new machine installed cost is $100,000 and requires minimal increase in NWC (net working capital). It will be sold at the end of year 3 for an anticipated $30,000. Use MACRS 3 yr. (Remember to add the terminal cash flow in when calculating year 3 OCF)
Anticipated cash flows prior to depreciation: Year 1 $40,000
Year 2 $48,000
Year 3 $20,000
Calculate the operating cash flows (OCF) for each year.
Calculate the NPV for this proposal if the cost of capital is estimated to be 10% and using OCFs from d.
What is the project IRR?
What is the project payback?
What is the project discounted payback?
Should they go forward with this project? Yes or no
Explanation / Answer
a) We have:
FV = 1000
N= 15 years
PV = 1152
Pmt = 1000 x 12% =120
We can use value of bond formula to compute pretax cost of debt:
Pre-tax cost of debt = 10.00%
After tax cost of debt rd= pre-tax cost x (1- tax rate)
= 10.00% x(1-0.4)
=6%
b) Using CAPM:
rS = Rf + ( Rm –Rf)xbeta
= 7% + (12%-7%)x1.2
=13%
c)
WACC = wd x rd + We x rs
=0.50 x 6% + 0.50 x 13%
=9.50%