WACC and Capital Budgeting Problem

Roger Clark opened a small restaurant business in Tennessee 10 years ago. His company grew and he decided to issue stock to the public 5 years ago and Rogers Restaurants Inc. (RRI) was formed. The stock currently sells for $15 a share and just paid an annual dividend of $0.75. This stock has a beta of 1.3. The company plans to increase dividends by 5% a year for the near future.

RRI currently has no publicly traded debt, but it does have long-term bank loans. RRI has approached their bank about additional loans and has been told that any new loans up to $1 million will have an APR of 6.5%.

RRIs target capital structure is 25% debt and 75% equity. RRIs marginal tax rate is 35%.

RRI is considering updating some kitchen equipment in four of the early restaurant locations. The new equipment and renovations will cost the company $150,000 per restaurant. Also sales will be negatively impacted in each of these locations for the renovation period. Overall, RRI predicts that sales will decrease by $25,000 at each restaurant for the first year of operation of the new equipment while the installation is completed. RRI forecasts that once the renovations are completed that store sales will return to the previous level. The new equipment is expected to reduce costs at each restaurant by $15,000 the first year and by $45,000 per year after that. The equipment will have a useful life of 6 years and has been classified as a 3-year asset for MACRS depreciation. The equipment will have a salvage value of $10,000 at the end of 6 years.

Treasury bonds are yielding 4% and analysts estimate that the S&P 500 will have an annual return of 10% in the next few years.

Based on the above information, should RRI undertake the renovations?