FIN311 In-class Assignment #3

Names _______________________________________________________________________________

Burton, a manufacturer of snowboards, is considering replacing an existing piece of equipment with a more sophisticated machine. The following information is given.

The proposed machine will cost $120,000 and have installation costs of $15,000. It will be depreciated using a 3 year MACRS recovery schedule. It can be sold for $60,000 after three years of use (at the end of year 3).

The existing machine was purchased two years ago for $90,000 (including installation). It is being depreciated using a 3 year MACRS recovery schedule. It can be sold today for $20,000. It can be used for three more years, but after three more years it will have no market value.

The earnings before taxes and depreciation (EBITDA) are as follows:

New machine: Year 1: 133,000, Year 2: 96,000, Year 3: 127,000

Existing machine: Year 1: 84,000, Year 2: 70,000, Year 3: 74,000

Burton pays 40 percent taxes on ordinary income and capital gains.

They expect a large increase in sales so their Net Working Capital will increase by $20,000.

Calculate the initial investment required for this project

Determine the incremental operating cash flows

Find the terminal cash flow for the project

Burton has determined its optimal capital structure, which is composed of the following sources and target market value proportions.

Debt: Burton can sell a 15-year, $1,000 par value, 8 percent annual coupon bond for $1,050. A flotation cost of 2 percent of the face (par) value would be required. Additionally, the firm has a marginal tax rate of 40 percent.

Common Stock: Burton's common stock is currently selling for $75 per share. The dividend expected to be paid at the end of the coming year is $5. Its dividend payments have been growing at a constant 3% rate. It is expected that to sell all the shares, a new common stock issue must be underpriced $2 per share and the firm must pay 1% of market value per share in flotation costs.

Calculate the after-tax cost of debt

Calculate the cost of equity (for new common stock issues)

Calculate the WACC

Burton wants to determine if replacing their machine will benefit their shareholders (see #1). They believe the cash flows are somewhat uncertain and adjust for risk using a RADR. For the level of risk they will be taking, they prefer using a RADR of 10%.Calculate the NPV and IRR using Burtons cost of capital (see #2).Calculate the NPV and IRR using the RADR.Should they purchase the new machine? Why or why not? Burton has established a target capital structure of 40 percent debt and 60 percent common equity. The firm expects to earn $600 in after-tax income during the coming year, and it will retain 40 percent of those earnings. The current market price of the firm's stock is P0 = $75; its last dividend was D0 = $4.85, and its expected dividend growth rate is 3 percent. Burton can issue new common stock at a 15 percent flotation cost. What will Burton's marginal cost of equity capital (not the WACC) be if it must fund a capital budget requiring $600 in total new capital