CFIN7 - CHAPTER 10
Integrative Problem 10-1
Unilate Textiles is evaluating a new product, a silk/wool blended fabric. Assume that you were recently hired
as assistant to the director of capital budgeting, and you must evaluate the new project.
The fabric would be produced in an unused building adjacent to Unilate’s Southern Pines, North Carolina
plant. Unilate owns the building, which is fully depreciated. The required equipment would cost $200,000,
plus an additional $40,000 for shipping and installation. In addition, inventories would rise by $25,000, while
accounts payable would go up by $5,000. All of these costs would be incurred at Year 0. By a special ruling,
the machinery could be depreciated under the MACRS system as 3-year property. (See Table 10A.2 at the
end of Chapter 10 for MACRS recovery allowance percentages.)
The project is expected to operate for four years, at which time it will be terminated. The cash inflows are
assumed to begin one year after the project is undertaken, or at t = 1, and to continue out to t = 4. At the end
of the project’s life (Year 4), the equipment is expected to have a salvage value of $25,000.
Unit sales are expected to total 100,000 five-yard textile rolls per year, and the expected sales price is $2
per roll. Cash operating costs for the project (total operating costs less depreciation) are expected to total
60% of dollar sales. Unilate’s marginal tax rate is 40%, and its required rate of return is 10%. Tentatively, the
silk/wool blend fabric project is assumed to be of equal risk to Unilate’s other assets.
You have been asked to evaluate the project and to make a recommendation as to whether it should be
accepted or rejected. To guide you in your analysis, your boss gave you the following set of tasks to
complete:
a. Draw a cash flow timeline that shows when the net cash inflows and outflows will occur, and explain how
the time line can be used to help structure the analysis.
b. Unilate has a standard form that is used in the capital budgeting process and shown in the following
table:
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in whole or in part.
Unilate’s Silk/Wool Fabric Project ($ Thousands)
End of Year:
0
1
2
Unit sales (Thousands)
100
Price/unit
$ 2.00
Total revenues
$200
Costs excluding depreciation
($120.0)
Depreciation
Total operating costs
$ 2.00
4
100
100
$2.00
$2.00
$200.0
($120.0)
($120.0) ($120.0)
(79.2)
(108.0)
( 36.0)
( 16.8)
($199.2)
($228.0)
(156.0)
(136.8)
$44.0
(63.2)
Earnings before taxes (EBT)
Taxes
100
3
(
0.8
(8.0)
0.3)
11.2
Net income
(17.6) ( 25.3)
$26.4
Depreciation
79.2
Supplemental operating CF
Equipment cost
$ 79.7
108.0
36.0
16.8
91.2
62.4
$ 54.7
(200.0)
Installation
(40.0)
Increase in inventory
(25.0)
Increase in accounts payable
5.0
Salvage value
25.0
Tax on salvage value
(10.0)
Return of net working capital
20.0
Cash flow timeline (net CF):
($260.0)
$79.7
Cumulative CF for payback:
( 260.0)
( 180.3)
$91.2
$62.4
$ 89.7
89.1
(26.7)
63.0
NPV =$4.0
IRR =
Payback =
Complete the table in the following order:
(1) Complete the unit sales, sales price, total revenues, and operating costs excluding depreciation
lines.
(2) Complete the depreciation line.
(3) Now complete the table down to net income and then down to net operating cash flows.
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in whole or in part.
KEY COST OF CAPITAL CONCEPTS
To conclude this chapter, we summarize some cost of capital
concepts (rules) that were discussed.
To make appropriate capital budgeting decisions,
the firm must know its required rate of return,
which is defined as the average rate of return that
the firm pays to attract investors' funds. Because
the firm pays the average rate of return to investors
who provide its long-term funds (capital), the firm's
required rate of return is also referred to as its cost
of capital.
To determine its required rate of return, the firm
must compute the cost of each source of funds or
capital that investors provide; that is, the firm must
compute the cost of debt, the cost of preferred
stock, the cost of retained earnings, and the cost of
new common equity. These costs are then combined
by weighting each component by the proportion
or weight that it contributes to the total capital of
PROBLEMS
11-1 Global Products plans to issue long-term bonds
to raise funds to finance its growth. The company
has existing bonds outstanding that are similar
to the new bonds it expects to issue. The existing
bonds have a face value equal to $1,000, mature
in 10 years, pay $60 interest annually, and are
currently selling for $1,077 each. Global's marginal
tax rate is 40 percent. (a) What should be the
coupon rate on the new bond issue? (a) What is
Global's after-tax cost of debt?
11-2 Notable Nothings plans to issue new bonds with
the same yield as its existing bonds. The existing
bonds have a coupon rate of interest equal to 5.6
percent (semiannual interest payments), 12 years
remaining until maturity, and a $1,000 maturity
value; they are currently selling for $918 each. (a)
If Notable issues new bonds today, what will be its
before-tax cost of debt? (b) What will be its before-
tax cost of debt if the price of its existing bonds is
$730 when Notable issues the new bonds?
11-3 Buoyant Cruises plans to issue preferred stock with
a $120 par value and a 5 percent dividend. Even
though the current market value of its preferred
the firm. The result is the weighted average cost
of capital, or WACC, which is the required rate of
return that the firm should use when making capital
budgeting decisions.
Investors who participate in the financial markets
determine firms' WACCs. Investors only provide
funds to firms if they expect to earn sufficient
returns on their investments; thus, firms must
pay investors' demands (required returns) to
attract funds.
When investing in capital budgeting projects, a firm
should follow the economics principle that asserts
products should continue to be manufactured
until marginal costs equal marginal revenues. That
is, the firm should invest until the marginal cost of
capital (marginal costs) equals the internal rate of
return on the last project that is purchased (marginal
revenues).
stock is $80 per share, Buoyant expects to net only
$75 for each share issued. What is its cost of issuing
preferred stock? The firm's marginal tax rate is
34 percent.
11-4 Jumbo Juice's preferred stock pays a constant divi-
dend equal to $4.75 per share. The firm's marginal
tax rate is 40 percent. Jumbo Juice incurs a 5 percent
flotation cost each time it issues preferred stock.
(a) If the firm issues 10,000 shares of preferred stock
at $50 per share, how much of the total value of the
issue will the firm be able to use (receive)? (b) What
is Jumbo Juice's cost of preferred stock?
11-5 Suppose the current risk-free rate of return is
3.5 percent and the expected market return is 9 percent.
Fashion Faux-Pas' common stock has a beta coefficient
equal to 1.4. Using the CAPM approach, compute the
firm's cost of retained earnings.
11-6 Suppose the current risk-free rate of return is
5 percent and the expected market risk premium
is 7 percent. Using this information, estimate the
cost of retained earnings for a company with a beta
coefficient equal to 2.0?
CHAPTER 11: The Cost of Capital 223
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