Capital Budgeting. (20 points) Your company is considering launching a new product. Designing the new product has already cost $700,000. The company estimates that it will sell 800,000 units per year for $3 per unit and variable non-labor costs will be $1 per unit. Production will end after year 4. New equipment costing $1 million is required. The equipment will be put into use next year (year 1) and depreciated to zero using the 5-year MACRS schedule. You plan to sell the equipment for book value at the end of year 5. Your current level of working capital is $300,000. The new product will require the working capital to increase to a level of $380,000 immediately, then to $400,000 in year 1, in year 2 the level will be $350,000, and finally in year 3 the level will return to $300,000. Your tax rate is 35%. The discount rate for this project is 10%.
Calculate depreciation expense for each year. (10 points)
Calculate Cashflows from the changes in NWC. (10 points)
Cost of Equity Capital. (15 points) IBM expects to pay a dividend of $3 next year and expects these dividends to grow at 8% a year. The price of IBM is $80 per share. Your estimate of the market risk premium is 9%. The risk-free rate of return is 4.1% and IBM has a beta of 1.5.
What is IBM cost of equity capital using the CDGM? (5 points)
What is IBM cost of equity capital using the CAPM? (5 points)
What growth rate would be necessary to make the answers converge? (5 points)
WACC. (15 points) GM is considering investing in a new plant that will save the company $20 million each year thereafter, to value this project they must calculate the WACC of the firm. Assume the market value of GM’s equity, preferred stock, and debt are $6 billion, $2 billion, and $13 billion, respectively. GM has a beta of 1.7, the market risk premium is 8%, and the risk-free rate of interest is 3%. GM’s preferred stock pays a dividend of $4 each year and trades at a price of $30 per share (hint: use the perpetuity formula). GM’s debt trades with a yield to maturity of 8.0%.
Calculate the costs of capital from equity, debt, and preferred stock. (5 points)
Calculate the capital structure weight for each source of capital. (5 points)
What is GM’s (after tax) weighted average cost of capital? (5 points)
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