Question 1: (20 marks)

On January 1, 2019, the total assets of the Dexter Company were $270 million. The firm's present capital structure, which follows, is considered to be optimal. Assume that there is no short-term debt.

Long-term debt $135,000,000

Common equity $135,000,000

New bonds will have a 10 percent coupon rate and will be sold at par. Common stock, currently, selling at $60 a share, can be sold to net the company $54 a share. Stockholders' required rate of return is estimated to be 12 percent., consisting of a dividend yield of 4 percent and an expected growth rate of 8 percent. (The next expected dividend is $2.40, so $2.40/$60 = 4%.)

Retained earnings are estimated to be $13.50 million. The marginal tax rate is 40 percent. Assuming that all asset expansion (gross expenditures for fixed assets plus related working capital) is included in the capital budget, the dollar amount of the capital budget, ignoring depreciation is $135 million. The marginal tax rate is 40 percent. Assuming that all asset expansion (gross expenditures for fixed assets plus related working capital) is included in the capital budget, the dollar amount of the capital budget, ignoring depreciation is $135 million.

Required:

1. To maintain the present capital structure, how much of the capital budget must Dexter finance by equity? (4 marks)

2. How much of the new equity funds needed will be generated internally? Externally? (3 marks)

3. Calculate the cost of each of the equity components. (5 marks)

4. At what level of capital expenditure will there be a break in Dexter's Marginal Cost of Capital schedule? (3 marks)

5. Calculate WACC.(5 marks)

Question 2 (50 marks)

Speedy Auto Wash is contemplating the purchase of a new high speed washer to replace the existing washer. The existing washer was purchased two years ago at an installed cost of $120,000; it has been depreciated under the MACRS using a 5-year recovery period.

5 year MACRS depreciation rates:

year %

1 20.00

2 32.00

3 19.20

4 11.52

5 11.52

The existing washer is expected to have a usable life of five more years. The new washer costs $210,000 and requires $10,000 in installation costs; it has a 5- year usable life and would be depreciated under the MACRS using a 5-year recovery period. The existing washer can currently be sold for $140,000 without incurring any removal or clean-up costs. To support the increased business resulting from purchase of the new washer, accounts receivable would increase by $80,000, inventories by $60,000, and accounts payable by $116,000.

At the end of five years, the existing washer is expected to have a market value of zero; the new washer would be sold to net $58,000 after removal and clean-up costs and before taxes. The firm pays taxes at a rate of 40 percent on both ordinary income and capital gains. The estimated profits before depreciation and taxes over the five years for both the new and existing washer are shown in the following table:

Year New Washer Existing Washer

1 $ 86,000.00 $ 52,000.00

2 $ 86,000.00 $ 48,000.00

3 $ 86,000.00 $ 44,000.00

4 $ 86,000.00 $ 40,000.00

5 $ 86,000.00 $ 36,000.00

Required:

1. Calculate the initial cash outflow associated with the replacement of existing washer with the new one. (15 marks)

2. Determine the incremental cash flows associated with the proposed washer replacement. Be sure to consider the residual depreciation in year 6. (20 marks)

3. Determine the terminal cash flow expected at the end of year 5 from the proposed washer replacement.(15 marks)

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