Question
New Horizons Co.s products are in high demand these days; as such, the firm wants to purchase a new machine to boost its productivity. After
New Horizons Co.s products are in high demand these days; as such, the firm wants to purchase a new machine to boost its productivity. After spending $45,000 on marketing research, New Horizons CFO believes that buying the new machine will increase the firms sales by 1 million dollars per year, and cost of goods sold by $0.2 million per year. Because of the new machine, New Horizons net working capital is expected to be $100,000 higher throughout the life of the new machine. New Horizons currently has enough workers to operate the new machine; however, some of the less skilled workers need further training which will cost the firm approximately $50,000. Of course, the training can only start when the new machine is in place.
The new machine has a price of 2 million dollars and falls into a MACRS ADS 3-year class; thus, it should be depreciated at 33.33%, 44.45%, 14.81% and 7.41% in years 1 through 4, respectively. The machine has an expected life of 4 years; after that, the manufacturer of the machine offers to recycle it for free. The new machine will occupy a small room which is currently used as a storage room; as a result, New Horizons will need to rent a new storage room for $20,000 a year (after-tax).
New Horizons currently faces a 35% tax rate. The firm has common shares and bonds only, and the firms capital structure is described in Table 2 below.
Table 2. New Horizons Debt and Equity
| Equity: | |
| Number of shares outstanding | 10,000,000 |
| Stock price | $5.50 |
| Cost of equity | 12% |
| Debt: | |
| Number of bonds issued | 50,000 |
| Par value | $1,000 |
| Years left until maturity | 20 |
| Coupon rate | 7% per year, semi-annual coupons |
| Current bond price | $900 |
- Please complete the table below to calculate financial cash flows.
Hint: In this case, EBIT = Sales - Cost of Goods Sold Depreciation
| Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | |
| EBIT | |||||
| - Taxes | |||||
| +Depreciation | |||||
| - NWC | |||||
| Capital Investment | |||||
| Other | |||||
| Financial Cash Flow |
- Use Table 2 to calculate New Horizons WACC. Should New Horizons go ahead to buy the new machine? Why?
- If the CFO wants a minimum return of 15%, should the new machine be purchased?
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