Sweet Jinks Limited which sells all classes of beverages, has asked you to estimate its cost of capital. Extracts from the most recent balance sheet of Sweet Jinks Limited are as follows:

Sweet Jinks Limited

Extracts Balance Sheet as at 30^th November 2020

1,000,000 Issued Ordinary Shares 4,000,000

5% Preference Shares @5 each 1,500,000

5% Bonds Redeemable at par 30/11/2026 1,500,000

• Ordinary shares are currently trading at $6.50.
• Preference shares have a market value of $2.90.
• Sweet Jinks main competitors, Island Gulp and Quench Quick have equity betas of 1.48 and 1.72 respectively.
• The interest rate on 3-month T-bills is 4% and the expected return on the market index is 10.5%.
• The bonds are presently trading at 97.
• Flotation costs on the new issuances of debt are 3%.
• Bond interest is paid semi-annually.
• Preference dividends are paid semi-annually.
• Corporate tax rate is 40%

Required:

1. Calculate Sweet Jinks after-tax cost of debt. (6 marks)
2. Calculate Sweet Jinks cost of equity. (5 marks)
3. Calculate Sweet Jinks cost of preferred shares. (5 marks)
4. Calculate Sweet Jinks Weighted Average Cost of Capital (8 marks)
5. Based on its capital structure, would you categorize this firm as being highly financially leveraged? What are the pros and cons of financial leverage. (4 marks)
6. Explain why using a firm's WACC is not always appropriate for the evaluation of a new project. (2 marks)

Section 3: Answer ALL questions in this section (15 marks)

Innova Inc plans to buy a new machine to replace an old machine. The new machine is expected to cost $850,000. The firm will also incur $100,000 in installation costs. The firm spent $35,000 researching the suitability of the new machine. The new machine has an expected life of five years. Additional investment in working capital of $80,000 will be required at the start of the first year of operation. An additional of $60,000 in working capital is expected at the end of year three. At the end of five years the machine will be sold for scrap, with the scrap value expected to be 5% of the initial purchase cost of the machine. The old machine was bought 5 years ago for $400,000 and now has a book value of $10,000. The market value of the old machine is $2,000.

Production and sales from the new machine are expected to be 120,000 units per year. Each unit will have a contribution margin of $6 in the first year, and selling price inflation will be 5% while variable cost inflation will be 2% thereafter. Prior to the purchase of the machine, total fixed costs per year were $200,000 but with new machine, total fixed costs will rise to $380,000 per year. During year 4, the company is expected to have an increase in maintenance expenditure of $75,000 due to the aging assets.

Innova Inc. has an after-tax cost of capital of 11% which it uses as a discount rate in investment appraisal. The company pays corporate profit tax at an annual rate of 30%

Required:

1. Calculate the net present value of investing in the new machine and advise whether the investment is financially acceptable. (12 marks)

2. Calculate the internal rate of return of investing in the new machine and advise whether the investment is financially acceptable. (3 marks)