Corporate Finance: Homework 3 Capital Budgeting Instructor: Supasith Chonglerttham, Ph.D. Due date: April 18 2017 Introduction You have recently been hired by Weston Inc., in the finance area. Weston Inc., is considering an expansion for its core business for year 2009 from two mutually exclusive projects. The projects being considered have similar risk characteristic to the company itself. Since the investment is part of company’s effort to expand its business, WI plans to use retained earnings and issue new bonds to facilitate one of the two projects as well as other new business investment being evaluated by your WI’s colleagues. WI’s marginal tax rate is 35%. The resulting capital structure is following: Addition to Retained Earnings $150,000,000 New Issue Debt $100,000,000 (Market Value) Stocks WI stock’s beta is 1.30. Currently, one-year T-bill rate is 2.5% and the S&P 500 index return is 7.5%. Additionally, starting from this year, WI plans to pay dividends at a growing rate of 3%. Last week, the company paid dividend of $1.5 per share. Bonds Currently, WI’s previously issued bonds are selling in the market for $875.65. The bonds will mature in 11 years, carry coupon rate of 8% and pay coupon annually. In order to pursue the investment, CFO of the company has negotiated with an investment bank and arrived at a conclusion that WI can issue new 10-year bonds with face value of $1,000 pay annual coupon of 11% and can be sold in the market for $1,100. The investment bank will charge 5.5% fee on selling price. WI will issue these bonds totaling $100,000,000. CF of the projects Machine A cost $95,000,000. This machine will increase earning before interest and taxes (EBIT) by $5,650,000 per year, on average, for the first 10 years. Starting from year 11, annual EBIT will increase at a very low growth rate of 1.5%. Assume that IRS allows this type of machine to be depreciated over 10 years. However, you know that this machine could last a really long time. Hence, you assume that Machine A will last forever. To operate the machine properly, workers have to go through a training session that would cost $600,000 after-tax. Additionally, it would cost $800,000 after-tax to install this machine properly. Machine A will also require that WI increase inventory of $2,000,000 to reach the most efficient machine capacity. The assignment Your boss requests that you analyze these two projects and make an investment recommendation. During a brief with him this morning, he asked you the following questions. Questions 1. What is the required rate of return on WI’s stock? 2. What should be WI’s current stock price? 3. What is the yield to maturity on WI’s outstanding bonds? 4. What would be the rate of return to investors from newly issued bonds? 5. Why are the [percentage] costs of currently outstanding debt and newly issued debt different? 6. What would be the [percentage] cost to the company from newly issued bonds? 7. What should be an appropriate hurdle rate [require rate of return] to evaluate these two new projects? 8. Evaluate projects’: NPV; PI; and IRR Note that each project has three different type of cash flow being evaluated 1) Initial Outlay 2) Annual free cash flow 3) Terminal cash flow and/or terminal value of all future cash flows