FIN 212 FINANCIAL MANAGEMENT PART II CAPITAL BUDGETING AND THE COST OF CAPITAL EXERCISES AND PROBLEMS PROBLEM

EM 1. Humble Manufacturing is interested in measuring its overall cost of capital. The firm is in the 40% tax bracket. Current investigation has gathered the following data: DEBT. The firm can raise debt by selling $1,000-par-value, 10% coupon interest rate, 10-year bonds on which annual interest payments will be made. To sell the issue, an average discount of $30 per bond must be given. The firm must also pay flotation costs of $20 per bond. PREFERRED STOCK.The firm can sell 11% (annual dividend) preferred stock at its $100-per-share par value. The cost of issuing and selling the preferred stock is expected to be $4 per share. COMMON STOCK. The firms common stock is currently selling for $80 per share. The firm expects to pay cash dividends of $6 per share next year. The firms dividends have been growing at an annual rate of 6%, and this rate is expected to continue in the future. The stock will have to be underpriced by $4 per share, and flotation costs are expected to amount to $4 per share. RETAINED EARNINGS. The firm expects to have $225,000 of retained earnings available in the coming year. Once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equity financing. REQUIRED: a. Calculate the individual cost of each source of financing. (Round to the nearest 0.1%.) b. Calculate the firms weighted average cost of capital using the weights shown in the following table, which are based on the firms target capital structure proportions.(Round to the nearest 0.1%.) Source of capital Weight Long-term debt 40% Preferred stock 15 Common stock equity 45 Total 100% PROBLEM 2. The Yum-Yum Roasters, Inc. wishes to expand and modernize its facilities. A computer controlled automatic roaster will cost them P120,000 with freight charges of P4,000. To make it fully operational, another P6,000 is needed to install it. The firm has a chance to sell its 4-year old roaster for P35,000. The existing roaster originally costs P60,000 and was being depreciated using the Modified Accelerated Cost Recovery System (MACRS) with a 5-year recovery period (see table below). Yum-Yum Roasters pays taxes at a rate of 40% on both ordinary income and capital gains. Anticipated changes in current assets and current liabilities are as follows: Account Accruals Inventory Accounts Payable Accounts Receivable Cash Notes Payable REQUIRED: Compute for the net initial investment of the new roaster. TABLE 1. MACRS Depreciation Table Recovery Year 3-Year 5-Year 7-Year 10-Year 1 33% 20% 14% 10 P Increase (Decrease) 20,000 50,000 40,000 70,000 --15,000

2 3 4 5 6 7 8 9 10 11

45 15 7

32 19 12 12 5

25 18 12 9 9 9 4

18 14 12 9 8 7 6 6 6 4

PROBLEM 3. A machine currently in use was originally purchased 2 years ago for $40,000. The machine is being depreciated under MACRS using a 5-year recovery period; it has 3 years of usable life remaining. The current machine can be sold today to net $42,000 after removal and cleanup costs. A new machine, using a 3-year MACRS recovery period, can be purchased at a price of $140,000. It requires $10,000 to install and has a 3-year usable life. If the new machine is acquired, the investment in accounts receivable will be expected to rise by $10,000, the inventory investment will increase by $25,000, and accounts payable will increase by $15,000. Profits before depreciation and taxes are expected to be $70,000 for each of the next 3 years with the old machine and to be $120,000 in the first year and $130,000 in the second and third years with the new machine. At the end of 3 years, the market value of the old machine will equal zero, but the new machine could be sold to net $35,000 before taxes. Both ordinary corporate income and capital gains are subject to a 40% tax. REQUIRED: a. Determine the initial investment associated with the proposed replacement decision. b. Calculate the incremental operating cash inflows for years 1 to 4 associated with the proposed replacement. (Note: Only depreciation cash flows must be considered in year 4.) c. Calculate the terminal cash flow associated with the proposed replacement decision. (Note: This is at the end of year 3.) PROBLEM 4. The Partnership of Hwe and Voz is considering three long-term capital investment proposals. Relevant data on each project are as follows: Projects Pugo Century Sal-Ao Capital Investment P 200,000 P 225,000 P 250,000 Annual net income: Year 1 25,000 20,000 26,000 Year 2 16,000 20,000 24,000 Year 3 13,000 20,000 23,000 Year 4 10,000 20,000 22,000 Year 5 8,000 20,000 20,000 P 72,000 P 100,000 P 115,000 Salvage value is expected to be zero at the end of each project. Depreciation is computed using straight-line method. The companys cost of capital is 12%. (Assume that cash flows occur evenly throughout the year.) REQUIRED: Compute for the following: 1. Payback Period 2. Payback reciprocal 3. Simple rate of return 4. Net present value 5. Discounted payback period (if applicable) 6. Present value index 7. Internal rate of return