Rick is the CFO of Hard Hat Equipment INC. The company is privately held and is in the business of making equipment for the construction industry. To expand its business, the leadership of the company is planning to build a new factory where processes are automated. This will result in a higher quality of construction equipment and enables the company to manufacture more products per month.

It is estimated that the cost of building this new factory and making it operational will cost $10 Million. In the last 5 years, the economy has gone through a construction boom and Hard Hat Equipment INC has been profitable. Through year-on-year high and positive retained earnings, the company has accumulated a cash position of $5 Million and the leadership has decided that it will use $4 Million of it towards building this new factory. The remaining $6 Million will be financed with new debt.

Hard Hat Equipment INC currently has debt on its books, with an average maturity of 10 years. The yield-to-maturity (YTM) of its current debt is 8.0% and its marginal tax rate is 25%.

If Rick is confident that he can raise new debt at the same YTM as its current debt. What is the after-tax cost of debt for this new project of financing a new factory? (5 points)

After a lengthy discussion with the companys investment bankers, Rick managed to secure new debt financing of $6 Million for the new factory. The YTM of the new bonds that were issued was 10%.

Give one reason why the YTM of the new bonds is higher than the YTM of the companys existing debt. (5 points)

To calculate the WACC, the cost-of-equity must first be determined. One of Ricks direct reports recommend using the pure play approach where the Beta is estimated off a publicly traded company. Using that approach, a Beta estimate of 1.1 is used for the equity portion of the financing. Assuming a market premium of 10% and a risk-free rate of 4%.

I. Calculate the Cost-of-Equity for this new factory project (5 points)

II. Calculate the WACC for this new factory project (5 points)

Rick disagreed with his teams calculation of the cost of equity. He argues that because this is a private company, and all the cash financing came from retained earnings which the company generated itself; the cost of equity should be zero! After all, why should the company be penalized for using its own money?

I. Is Rick correct? (2 points)

II. Explain your answer (3 points)