1. A firm is considering the purchase of new equipment to replace some old existing equipment. The old equipment will be fully depreciated and has a current market value of $1.2 million. The new equipment costs $10.4 million and will be depreciated using the 5 year MACRS class schedule. The equipment is used to produce items with constant annual revenues of $18 million. Current costs using the old equipment are $3 million per year. The new equipment will not change the expected revenues (they will remain at $18 million per year), but will allow the firm to cut costs by $1 million per year. The project is expected to last for 4 years, at which time the new equipment will be worth $6 million. If the old equipment is kept, it will be worthless in 4 years.The tax rate faced by the firm is 35%.

Year 1 2 3 4 5

Equipment MACRS % 20% 32% 19.20% 11.52% 11.52%

Building MACRS% 3.042% 3.175% 3.175% 3.175% 3.175%

a. Calculate the Cash flows to the firm.

b. Suppose that this is a privately held firm and hence has no price data from which to estimate the stock's beta. Suppose the average regression beta for the comparable firms is 1.675, and the average debt to equity ratio for the comparables is 6.75%. Additionally, the tax rate faced by the comparables is 35%. Use this information in order to calculate the bottom-up beta for this firm assuming that this firm will use a D/E ratio of 7.5% and face the same tax rate as the comparables.

c. What would be the estimate (using the bottom-up method) you would use for the cost of equity for this firm, if the risk free rate is 5% and the default spread over the risk free rate is .8%?

d. Suppose also for this firm that the pretax cost of debt is 5.8%. Find the WACC for this firm.

e. Using the WACC for this firm that you calculated above, evaluate according to NPV whether or not this firm should purchase this new equipment.