Question No. 3

Part A

ABC company has bond outstanding of 100,000 selling at par. Similar bonds in the market have a yield rate of 7.5%. In its capital structure, the company also has 5 million common shares outstanding and one million preference shares outstanding of 10.5%. The systematic risk of the firm is 1.2 and has a stock price of $38. Preferred shares are trading in the market at a price of $56 per share. The market return is 12 percent, and the risk-free rate is 3 percent.

Required

Calculate the WACC of ABC company.

Part B: \

Refreshment inn is a small refreshment business. It currently rents the bottling machine for its operations and pays a yearly rent of $54000. The rent is inclusive of all the maintenance expenses. The owner of the business is now planning to buy his machine instead of renting it. For this purpose, he is considering two choices.

• The first choice is to buy the existing machine that the business is renting. The machine will cost the business $16500. Moreover, the business has to incur an annual maintenance expense of $22000 on this machine.

• The second choice is to buy a new machine for $255000. This machine is an improved version of the existing machine and uses the latest technology. The new machine has a maintenance cost of $18000 per year and will decrease the annual bottling cost of the business by $15000. Furthermore, the business must incur an upfront cost of $38000 for the training of the new operators.

Lets consider that the business uses the discount rate of 7 percent of ad machines are bought today. Assume that business uses straight-line depreciation method and machines have a useful life of 10 years. The tax rate is 38 percent.

Required:

Should the business buy a new machine, an existing machine, or continue renting? Evaluate.