Burberry Group PLC is a British fashion clothing company. It is considering the replacement of one of its existing machines with a new model. The existing machine can be sold now for 10,000. The new machine costs 60,000 and will generate free cash flows of 12,560 p.a. over the next 5 years. The corporate tax rate is 30%. The new machine has average risk. Burberry's debt-equity ratio is 0.4 and it plans to maintain a constant debt-equity ratio. Burberry's cost of debt is 6.30% and its cost of equity is 14.25%. a. Compute Burberry's weighted average cost of capital. (5 marks) b. What is the NPV of the new machine and should Burberry replace the old machine with the new one? (5 marks) c. The average debt-to-value ratio in the fashion clothing industry is 20%. What would Burberry's cost of equity be if it took on the average amount of debt of its industry at a cost of debt of 5%? Do this calculation assuming the company does not pay taxes. (5 marks) d. Given the capital structure change in question c), Modigliani and Miller would argue that according to their theory, Burberry's WACC should decline because its cost of equity capital has declined. Discuss. (10 marks) e. How could the capital structure change in question c) be explained based on what we know from the trade-off theory of capital structure? Assume the debt-to-value ratio of 20% is the new optimal capital structure for Burberry. (10 marks) Burberry Group PLC is a British fashion clothing company. It is considering the replacement of one of its existing machines with a new model. The existing machine can be sold now for 10,000. The new machine costs 60,000 and will generate free cash flows of 12,560 p.a. over the next 5 years. The corporate tax rate is 30%. The new machine has average risk. Burberry's debt-equity ratio is 0.4 and it plans to maintain a constant debt-equity ratio. Burberry's cost of debt is 6.30% and its cost of equity is 14.25%. a. Compute Burberry's weighted average cost of capital. (5 marks) b. What is the NPV of the new machine and should Burberry replace the old machine with the new one? (5 marks) c. The average debt-to-value ratio in the fashion clothing industry is 20%. What would Burberry's cost of equity be if it took on the average amount of debt of its industry at a cost of debt of 5%? Do this calculation assuming the company does not pay taxes. (5 marks) d. Given the capital structure change in question c), Modigliani and Miller would argue that according to their theory, Burberry's WACC should decline because its cost of equity capital has declined. Discuss. (10 marks) e. How could the capital structure change in question c) be explained based on what we know from the trade-off theory of capital structure? Assume the debt-to-value ratio of 20% is the new optimal capital structure for Burberry. (10 marks)
