answer #6
Computerized Business Systems (CBS) transforms manual accounting and inventory systems into computerized, more efficient, systems. Many of their customers describe the transition as an overnight evolution from the dark ages to the 21st century. Manual systems are far too cumbersome with respects to both time and inventory control. CBS's computerized inventory systems, for example, allow every item in inventory, no matter how small, to be tracked at all points throughout the production process. Replenishing stock becomes an automatic process because the CBS system alerts the manager when supplies reach a pre-programmed level. Vicky Pagel has been a financial analyst with CBS for over five years. Although she normally does not get involved with sales, her most recent assignment was to assist Jack Ingram, a new sales representative. Jack is in the process of trying to sell a CBS system to Corbin Mills, a firm that does not know how to determine accurately its capital budgeting decisions. To calculate Corbin Mills' WACC, Vicky first needed to gather information on the firm's cost of raising funds from various sources. As she proceeded with the analysis, she learned that Corbin Mills could issue 20-year corporate bonds at a coupon rate of 9%. As a result of current interest rates, the bonds could be sold for $1,005 each. These bonds have flotation costs of $35 per bond, pay interest annually, and have a par value of $1,000. A corporate tax rate of 40% applies. Corbin Mills can raise additional funds through retained earnings or new issues of common stock. Vicky estimates that Corbin will have $240,000 of retained earnings available for this project. Their common stock is currently seling for $68.25 per share. The most recent dividend paid was in the amount of $2.25. Corbin's dividends have previously grown at a rate of 8%, and this growth rate is expected to continue indefinitely. If the firm wanted to sell new shares of common stock, after underpricing and flotation costs, they could do so for $62.75 per share. A final source from which funds could be raised is via preferred stock. $100-par preferred stock can be issued at an 11% annual dividend rate. After flotation costs, the preferred stock would sell for $95.50 per share. Vicky has determined Corbin Mills' target or optimal capital structure to be 35% Debt, 5% Preferred Stock, and 60% Common Equity Vicky has also estimated the following cash flows associated with the project: The cost of the CBS system will be $450,000; Corbin Mills will need to increase their net working capital by $30,000 to implement the new CBS system; Implementation of the CBS system should generate $80,000 of net after-tax operating cash flows each year for the ten years under consideration; and At the end of the project, the CBS system could be sold to net Corbin Mills $10,000 after-tax. Put yourself in Vicky Pagel's position and evaluate this project for Corbin Mills. Since Jack will be the only one involved in communicating with Corbin Mills, he must completely understand all of the assumptions and calculations that will be made throughout the analysis. For this reason, the analysis must be clear as well as technically correct. Questions: 1. What is the net initial investment (NINV) for the CBS system? 2. What is the total cash flow associated with the project in year 10, the terminal year of the project? 3. What is the firm's after-tax cost of preferred stock? 4. What is the firm's after-tax cost of long-term debt? 5. What is the firm's after-tax cost of retained earnings? 6. What is the firm's after-tax cost of new common stock? 7. What is the weighted average cost of capital (WACC) that Corbin Mills should apply to this project? 8. Would Corbin Mills be better off with the new CBS system? In other words, what are the NPV, PI and IRR of the system proposed by CBS
