Case:

AAA Health, Inc. (NYSE: A3H) is evaluating a new product, a vitamin C/fish oil blended energy drink. As an assistant director of the capital budgeting division of AAA Health, you are responsible for evaluating the proposed project. You collected the following information about the project and the cost of capital. You should make an accept/reject recommendation to the director of your division based on your evaluation.

Information about the Proposed Project:

Initial investment and depreciation: The new drink would be produced in an unused building (owned by AAA Health), which is fully depreciated. The new equipment required for the project would cost $400,000, plus an additional $50,000 for shipping and installation. With the new project, inventories would rise by $60,000, and accounts payable would increase by $10,000. All of these costs would be incurred at t = 0. The machinery will be depreciated under the Modified Accelerated Cost Recovery System (MACRS) as 3-year property. The depreciation rates are 33% at t = 1, 45% at t = 2, 15% at t = 3, and 7% at t = 4. Project life and salvage value: AAA Health expects to run the project for four years. The cash inflows are assumed to begin one year after the project is undertaken, or at t = 1, and to continue to t = 4. At the end of the projects life (t = 4), the equipment is expected to have a salvage value of $50,000. Also, the firm will recover the net working capital at the end of the project life. Sales and operating costs: Unit sales are expected to total 160,000 bottles per year, and the expected sale price is $2.50 per bottle. Cash operating expenses for the project (total operating costs excluding depreciation) are expected to amount to 40 percent of sales revenue. Tax rate: AAAs marginal tax rate is 25 percent.

Information for the Cost of Capital Estimation:

AAA Health has outstanding bonds with a 4.40% annual coupon rate, 10 years remaining until maturity, and a face value of $1,000. The bonds make semiannual coupon payments and are currently trading in the market at a price of $880.98. A3H can issue preferred stock with an offering price of $25.00 per share, an annual per-share dividend of $2.16. Flotation costs are equal to 4.0% of the gross proceeds. Ten-year Treasury bond yield = 5%; the market risk premium = 5%; the beta of A3H = 1.2. Target weight of capital: 20 percent debt, 10 percent preferred stock, and 70 percent common equity. A3H can undertake a new project without issuing new shares of common stock if the required initial investment does not exceed $600,000. If the initial investment is greater than $600,000, the firm should sell new common stock.

Instructions: Please read carefully and work accordingly:

1. Show all work including setting up necessary equations with the proper inputs identified. If you show only the final results, you will get a score of zero without exception. 2. The project should be done with Microsoft Word or Excel. Do not use Apple Pages. I will not consider any jpeg files (or jpg files) of pictures of handwritten papers and PDF files as acceptable submissions. When you type formulas and/or equations in MS Word, please use the equation editing function (Insert > Equation). You can use an Excel spreadsheet to show your work. As long as I can click on the cells and see your inputs, you will be fine. 3. Use four decimal places for your calculations. Show your answers by rounding the calculation results to the nearest whole number if answers are in dollars. For example, if your calculation results in $100.1265, show your answer as $100. If you need to show your answers as a percent, take four decimal places from your calculation, converting them into a percent. For example, if your calculation results in 0.4567, show 45.67%, not 46%. To set your Texas Instrument BA II PLUS calculator at 4 decimal places, press [2ND] FORMAT 4 [ENTER]. 4. Do NOT show financial calculator keys. If you show financial calculator keys with your results instead of showing equations with the proper inputs plugged in, you will receive a score of zero.

Questions :

Part I. WACC Estimation:

1. Estimate the cost of debt before-tax. 2. Estimate the cost of debt after-tax. 3. Estimate the cost of preferred stock. 4. Estimate the cost of common equity. 5. Estimate the WACC.