Question
One of your best friends started to work in the finance department of a American multinational company called (THI) that produces wands and broomsticks. Currently,
One of your best friends started to work in the finance department of a American multinational company called (THI) that produces wands and broomsticks. Currently, THI is financed by common stock and bonds only.
The company has 1,388.5 million worth of 10 par value stocks outstanding on its books today. THI has been changing its production process for a while now. Thus, it did not distribute any dividends for the last three years. The company plans not to distribute dividends for another year. At the end of two years from today, THI will distribute 2 per share as dividends to its stockholders. After the company starts distributing dividends at the end of year 2, the company's dividends will grow by 25% for two years and 10% for an additional year, according to the finance manager. After five years from today the dividend growth rate will stabilize at 5% and stay at the level forever. The market risk premium is 10%, and the risk-free rate is 3%. The beta of THI is estimated to be 1.2 by the financial analysts.
Today THI has 1,250,000 bonds outstanding with a total market value of 1,464,487,500. These bonds have a 1,000 par value each, and they are issued five years ago with an original maturity of 25 years. The bonds have a 12% coupon rate and make semi-annual coupon payments.
a. Calculate the cost of equity for the THI.
b. Calculate the cost of debt for the THI.
c. If THI is in the 30% tax bracket, calculate the WACC for the company.
d. The Hogwarts Inc. claims that they produce the best broomsticks for Quidditch. They continually improve their broomsticks and production process to keep their promise. Recently, the production department submits its request to upgrade Nimbus 2015 used for broomstick production to Nimbus 2021.
The company bought Nimbus 2015 five years ago for 250,000 and depreciated it to 0 over 10 years by straight-line depreciation. Today, its market value is 110,000. If THI continues to use Nimbus 2015 for another five years, then its market value will be 10,000 at that time.
On the other hand, Nimbus 2021 costs 400,000 today, and another 2,500 is needed for installation. Nimbus 2021 should also be depreciated to 0 with straight-line depreciation over 10 years. However, the finance manager of THI knows that these machines can be used efficiently just for five years, and then need to be replaced by a newer model. At the end of five years, the market value of Nimbus 2021 is estimated to be 260,000.
Since Nimbus 2021 has more advanced technology, the company can decrease its raw material inventory by 30,000 today and keep it at that level for the next five years. Nimbus 2021 will help THI to increase their revenues by 40,000 and decrease their costs by 15,000 per year for the next five years. This replacement will not have any effect on the riskiness of the THI company.
Decide if it is beneficial for THI to replace Nimbus 2015 with Nimbus 2021 today and briefly state why.
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