Problem 1:

You just graduated from Saint Marys University with a Bachelors of Commerce and joined Irving Shipbuilding Inc. (Irving), one of Eastern Canadas leading industrial groups. The financial manager of Irving, Mike, is evaluating a new project and asked you to help him evaluate a new project.

Irving currently has $50,000,000 in bonds outstanding with a coupon rate of 5% paid semiannually and a maturity of 10 years. The bonds are currently selling at a quoted price of 95. The company also has 30,000 shares of 8% preferred stock outstanding ($100 par), currently selling for $95 per share. In addition, the company has 1,000,000 common shares outstanding, selling for $60 per share. The firm has a tax rate of 40%, a beta of 1.5, an ROE of 20%, and a dividend payout ratio of 20%. The firm just paid an annual dividend of $2 per common share. Flotation cost to issue new debt is 2%, new preferred share is 4%, and new common share is 10%. The firm has $5,000,000 in internally generated funds available.

a) Calculate the discount rate the firm should use to evaluate projects with the same level of risk as the firm

b) Over the last two years, Irving incurred a cost of $100,000 for conducting a feasibility study on a new project. The project requires purchasing a new machine that will cost $2,000,000 plus an additional $200,000 in installation costs. Management estimates that the firm will obtain annual operating revenues before taxes of $1,000,000 and incur annual operating expenses before taxes of $500,000 over the economic life of the project. The specifications of this machine indicate an economic life of ten years and management estimates that at the end of the economic life, the machine will have a salvage value of $200,000. This machine is in asset class 8 which has a CCA rate of 20%. The asset class is expected to remain open at the end of the project. Finally, management expects to make an initial investment in working capital of $200,000, which will be recovered at the end of the economic life of the project. Based on NPV analysis, should the project be undertaken? Assume this project will have the same level of risk as the firm. Also, assume that the initial investment in working capital is part of the capital that needs to be raised.

c) Compute the annual operating revenues before taxes for which you should be indifferent between taking and rejecting the project. Assume that the annual operating expenses before taxes are equal to 50% of the annual operating revenues before taxes. Also, assume that all other numbers are unchanged.