S & P Corporation (SPC) has an optimal capital structure of 40 percent debt and

Question

S & P Corporation (SPC) has an optimal capital structure of 40 percent debt and 60 percent equity.
Given the following information, calculate the marginal cost of capital (MCC) schedule and the optimal
capital budget (e.g. how much is the optimal capital budget and what is the corporate cost of capital?).
• 5 years ago, the company issued callable bonds that pay semiannual payment with 6.5%
annual coupon rate and sold them at par value ($1,000). However, each bond is currently
selling at $1,040 and has 15 years remaining to maturity.
• SPC’s current stock price is $50.00, its long run growth rate is 3% and its expected earnings
per share (EPS1) is $4.00. The company retains 20% of its earnings to fund future growth.
• There are 102.5 million common shares outstanding.
• New common stock may be issued with 5 percent flotation costs.
• SPC has the following Investment Opportunity Schedule(IOS):
Project IRR Cost (millions)
A 15.2% 20
B 12.5% 55
C 9.0% 45
D 7.5% 40
E 6.0% 50
Problem 2 (50 points)
S & P Corporation (SPC) is considering entering a new line of business. In analyzing the potential
business, the financial staff has accumulated the following information:
• The new business will require a capital expenditure of $7 million at t = 0. This expenditure
will be used to purchase new equipment.
• This equipment will be depreciated according to MACRS five-year class (see table next
page).
• The equipment will have a salvage value of $500,000 after five years.
• If SPC goes ahead with the new business, inventories will rise by $300,000 whereas accounts
payable will rise by $200,000 (both at t = 0). As a matter of fact, the required level of
working capital is 2.5% of expected sales over the year:
WCt = 2.5%*Salest+1
• The new business is expected to have an economic life of five years.
• The Marketing Department forecasts to sell 300,000 units during the first year and then
400,000 units thereafter. The expected price is $10 per unit during the first year. Price must
be adjusted by inflation in subsequent years.
• During the first year, variable cost is expected to be $6.00 per unit whereas fixed cost is
$100,000. These figures must be adjusted by inflation in subsequent years.
• The new product is expected to increase before-tax cash flows of the company’s existing
products by $300,000 per year in real terms. This amount also has to be adjusted by
inflation.
• The expected inflation rate during the life of the project is 2% per year.
• The company’s interest expense each year will be $220,000.
• The company’s tax rate is 40%.
• The company is very profitable, so any accounting losses on this project can be used to
reduce the company’s overall tax burden.
• The company’s cost of capital (WACC) is 7.10%. However, the proposed project is riskier
than the average project for SPC and therefore you have to add 2% to the corporate cost of
capital.
The company’s CFO wants you to analyze the project and to write a short report with your
recommendation. Please be advised that the report will be read by both financial and non-financial
managers, therefore, make sure you explain your calculations and recommendation.
MACRS 5-year class
Depreciation
Year Rates
1 0.20
2 0.32
3 0.19
4 0.12
5 0.11
6 0.06
Problem 3 (Problem 20 points).
Aggarwal Enterprises is considering a new project that has a cost of $1,000,000, and the CFO set
up the following simple decision tree to show its three most likely scenarios. The firm could
arrange with its work force and suppliers to cease operations at the end of Year 1 should it
choose to do so, but to obtain this abandonment option, it would have to make a payment to
those parties. Calculate the project’s coefficient of variation.
WACC = 7.10% Dollars in Thousands
t = 0 t = 1 t = 2 t = 3
Prob. = 20% $800.0 $800.0 $800.0
Prob. = 60% -$1,000 $520.0 $520.0 $520.0
Prob. = 20% -$200.0

Explanation / Answer

3)

NPV without abondonment option NPV this Prob*NPV WACC = 7.10% t=0 t=1 t=2 t=3 State Prob 20% 800 800 800 $1,095.62 $219.12 Prob 60% -1000 520 520 520 $259.76 $155.86 prob 20% -200 -200 -200 ($1,523.91) ($304.78) Expected NPV $70.20 NPV without abondonment option NPV this Prob*NPV WACC = 7.10% t=0 t=1 t=2 t=3 State Prob 20% 800 800 800 $1,095.62 $219.12 Prob 60% -1000 520 520 520 $259.76 $155.86 prob 20% -200 0 0 ($1,186.74) ($237.35) Expected NPV $137.63 Value of abondonment option $67.43

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