Gizmo Inc has outstanding 30-year bonds with an 8% coupon rate, annual payments

Question

Gizmo Inc has outstanding 30-year bonds with an 8% coupon rate, annual payments selling for $1,150. Its preferred stock is selling for $75 and pays a fixed dividend of $7.5. Gizmo Inc. common stock is selling for $100 and has a beta of 2. The last dividend paid was $10 and dividends are expected to grow at 10% a year. The target Capital structure calls for 30% debt, 10% Preferred Stock, and 60% Common Equity.

Gizmo Inc. is considering the purchase of a new machine to replace an old one. The original cost of the old machine was $50,000; it is now 1 year old and has a market value of $33,500. It is being depreciated using the MACRS 3-year class life and can be used for three more years at which time it will be worthless. The cost of the replacement machine is $100,000, has a useful life of 3 years, and an estimated market value of $14,000 at the end of three years. Sales are expected to increase by $75,000 per year. The new machine will be depreciated using the MACRS 3-year class life.

The firm has a marginal tax rate of 40%. The MACRS 3-year class life rates are 33%, 45%, 15% and 7%.

1. what is before tax cost of debt?

2. after tax cost of debt?

3. preferred stock?

4. common equity?

5. after tax cash flow from the scale of the machine at time 0?

6. change in depreciation for year 1?

7. change in depreciation for year 2?

8. change in depreciation for year 3?

9. What is the after-tax cash flow from the sale of the new machine at the end of the third year?

10. What is the Free Cash Flow for year 0?

11. What is the Free Cash Flow for year 1?

12. What is the Free Cash Flow for year 2?

13. What is the Free Cash Flow for year 3?

14. what is the IRR for the project?

Explanation / Answer

1)

Coupon Rate = 8%

Face Value = 1000

Coupon Value = Coupon Rate * Face Value = 8%*1000 = 80

Current Price = 1150

Maturity = 30 years

In order to find the before-tax cost of debt, we need to calculate the yield of the bond. We will us the RATE formula in excel to find the yield

= RATE(Maturity, Coupon, Current Price, Face Value) [Current Price is taken as negative to denote cash outflow]

=RATE(30,80,-1150,1000) = 6.8%

Before-tax cost of debt is 6.8%

2)

Marginal tax rate for firm = 40%

After tax cost of debt = Before tax cost of debt * (1-Tax Rate) = 6.8% * (1-40%) = 4.1%

3)

Fixed Dividend for Preferred Stock = 7.5

Current Selling Price of Preferred Stock = 75

Cost of Preferred Stock = Fixed Dividend/Current Selling Price = 7.5/75 = 10%

4)

Current Selling Price of Equity = 100

Last Dividend = 10

Expected Annual Growth of Dividend = 10%

In order to find the cost of equity, we will use dividend-discount model

As per dividend-discount model

Value of equity = Last Dividend*(1+Growth)/(Cost of Equity - Growth)

100 = 10*(1+10%)/(Cost of Equity - 10%)

100 = 11/(Cost of Equity - 10%)

Cost of Equity - 10% = 11/100 = 11%

Cost of Equity = 11%+10% = 21%

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