Kentucky Hardware Company (KHC) is considering an investment project that requir

Question

Kentucky Hardware Company (KHC) is considering an investment project that requires a new machine for producing special tools. This new machine costs $1,000,000 and will be depreciated over 10 years on a straight-line basis toward zero salvage value. KHC paid a consulting company $50,000 last year to help them decide whether there is sufficient demand for the special tools. In addition to the investment on the machine, KHC also invests $30,000 in net working capital. The company pays $45,000 in interest expenses annually. KHC has estimated the performance of the new machine and believes that the new machine will produce $350,000 per year in sales, $130,000 per year in cost of goods sold, and $25,000 per year in administrative expenses.

In order to get an estimate of cost of capital, KHC collect the following information. KHC has 310,000 shares of common stock outstanding, 15,000 shares of preferred stock outstanding, and 8,000 issues of corporate bond outstanding. The bonds have face value $1,000 and coupon rate 6%. The bonds make semiannual coupon payments, have 25 years to maturity, and sell for 131.423% of par. The common stock sells for $56 per share and has a beta of 1.05. KHC’s next common stock dividend is expected to be $2.80 per share, and the common stock dividend is expected to grow at 7.7% indefinitely. The preferred stock sells for $72 per share and pays $4.5 annual dividend. The market risk premium is 8%, T-bills are yielding 4.5%, and KHC’s tax rate is 25%.

Use the above information to answer Questions 1 - 17.

Explanation / Answer

1) MARKET VALUE CAPITAL STRUCTURE: Equity = 310000*56 = $        1,73,60,000 Preferred stock= 15000*72= $            10,80,000 Debt = 8000*1000*131.423%= $        1,05,13,840 Answer: Option [a] $        2,89,53,840 2) Cost of preferred stock = 4.5/72 = 6.25% Before tax cost of deht= YTM = 4% (the YTM is calculated using an online calculator) After tax cost of debt = 4*(1-0.25) = 3.00% Cost of equity: As per CAPM = 4.5+1.05*8 = 12.90% AS per dividend growth model = 2.80/56 + 0.077 = 12.70% Average of the above two 12.80% WACC: Market value Weight Component cost WACC Equity = 310000*56 = $        1,73,60,000 0.5996 12.8 7.67 Preferred stock= 15000*72= $            10,80,000 0.0373 6.25 0.23 Debt = 8000*1000*131.423%= $        1,05,13,840 0.3631 3.00 1.09 Total $        2,89,53,840 9.00 WACC = 9% Option [a] 3) Initial Investment = 1000000+30000= 1030000 Annual OCF: Sales 350000 COGS 130000 Admn expenses 25000 Depreciation (1000000/10) 100000 NOI 95000 Tax at 25% 23750 NOPAT 71250 Add depeciation 100000 Annual OCF 171250 Payback = 1030000/171250 = 6.01 Years Answer: Option [a] 4) PV of the OCF at 9% = 171250*(1.09^10-1)/(0.09*1.09^10) = $      10,99,023.88 PV of NWC = 30000/1.09^10 = $            12,672.32 PV of cash inflows $      11,11,696.21 Less Initial investment $      10,30,000.00 NPV $            81,696.21 Answer: Option [a]

Related Questions

Navigate

• Browse (All)
• Browse K
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.