Life is messy and deciding how to allocate capital resources is complicated. So, unlike the highly...

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Finance

Life is messy and deciding how to allocate capitalresources is complicated. So, unlike the highly simplified problemsused in class (and in the online examples, homework, etc.), this isa more robust capital budgeting decision problem.
Acme Manufacturing, Inc. was originally a family ownedoperation that has been in business for several generations. It hasgrown steadily and is now listed on the stock exchange with familymembers still owning a substantial portion of the shares. Over theyears, the company has acquired a reputation for exceptionalquality and has won awards from major customers.
The firm is 75% equity financed; shares currentlytrade at $37 and do not pay a dividend. Debt capital is provided bya single issue of bonds (20 year, $1,000 par value, $85 coupon)currently trading at $1,094. The firm’s beta is 1.25. Theirtraditional hurdle rate has been 12%, though the rate has not beenreviewed in many years. Over the years, shareholders have come toexpect a 10% return. Their corporate tax rate is 25%. Treasurysecurities are yielding 4.75%. The market rate of return onequities
is 8.25%.
They are currently using several old-style machinesthat together had cost $700,000. Depreciation of $220,000 hasalready been charged against this total cost; depreciation chargesare $80,000 annually. Management believes these machines will needto be replaced after eight more years. They have a current marketvalue of $205,000.
The old machines require eleven workers per shiftearning $14.50/hr plus three maintenance workers paid $13.50/hr.The plant operates day and afternoon shifts five days each week;maintenance workers are assigned to the afternoon shift only.Maintenance expenses have been running at $5,500 annually; the costof electricity has been $26,000 per year. The production process isnot only labor intensive, but also physically demanding. Workplaceinjuries are not uncommon and lately medical claims have beenincreasing.
The Machine Tool Division is considering the purchaseof a piece of highly-automated, robotic production equipment. Itwould replace older machines and would offer improvements inquality, and some additional capacity for expansion. Because of themagnitude of the proposed expenditure, a careful estimate of theprojects costs and benefits is needed.
The new machine will have a total cost that includesshipping, installation and testing of $1.5 million. The plant willalso need $350,000 in modifications to accommodate the new machine.These costs will
be capitalized and depreciated over the eight-year estimated lifeof the machine. The new machine would require only two skilledoperators (one per shift) who would earn $25/hr. Maintenance willbe outsourced and cost $90,000 per year. The annual cost ofelectricity is estimated to be $50,000.
Certain aspects of the decision are difficult toquantify. The most obvious is that Management’s relationship withthe union hasn’t always been a smooth one and union leadership maynot agree to the layoff of the redundant workers. Reassigning themto positions in other divisions might be easierbut there arecurrently only a handful of suitable openings, some of which arenot in the collective bargaining unit.
The specs on the new machine indicate that even higherlevels of product quality and lower scrap ratesare possible. Inlight of ever-increasing competition, this might prove to be ofenormous competitive
advantage. The new machine has a maximum capacity 27% higher thanthe old semi-automated machines which are currently operating at90% capacity.
Assignment Parts:
a. Calculate the firm’s Weighted Average Cost of Capital.
b. Identify and analyze the relevant cash flows forthe two alternatives - buying the new machine vs. continuing to usethe old ones.
c. List and describe briefly any areas of uncertaintyor concern for this project. What effect might
they have? Bullet points are just fine.
d. Based on your results in parts b & c, explainwhy you would or would not proceed with the new
machine.

Answer & Explanation Solved by verified expert

4.2 Ratings (858 Votes)

Answer a Weighted Average Cost of Capital Particulars Value Market Value Equity weight 7500 3700 Debt weight 2500 109400 Debt Maturity Time 20 years Debt Issue rate Par Value 100000 Debt Coupon 8500 Debt Coupon Rate Coupon Par Value 850 Beta 125 Existing Hurdle Rate 1200 Shareholder Expected Return 1000 Corporate Tax 2500 Treasury Security yield 475 Market Rate of Return on Equity 825 Cost of Equity Using Capital Asset Pricing Model CAPM Value Cost of Equity CoE Rm BRm Rf where Rm Market Return B Beta of Firm Rf Risk free return on treasury CoE 825 125825 475 1263 Cost of Debt Cost of Debt CoD Interest Expense or Coupon Rate1 Corporate Tax Rate CoD 850 125 638 Weighted Average Cost of Capital WACC WACC See Answer

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Transcribed Image Text

Life is messy and deciding how to allocate capitalresources is complicated. So, unlike the highly simplified problemsused in class (and in the online examples, homework, etc.), this isa more robust capital budgeting decision problem.Acme Manufacturing, Inc. was originally a family ownedoperation that has been in business for several generations. It hasgrown steadily and is now listed on the stock exchange with familymembers still owning a substantial portion of the shares. Over theyears, the company has acquired a reputation for exceptionalquality and has won awards from major customers.The firm is 75% equity financed; shares currentlytrade at $37 and do not pay a dividend. Debt capital is provided bya single issue of bonds (20 year, $1,000 par value, $85 coupon)currently trading at $1,094. The firm’s beta is 1.25. Theirtraditional hurdle rate has been 12%, though the rate has not beenreviewed in many years. Over the years, shareholders have come toexpect a 10% return. Their corporate tax rate is 25%. Treasurysecurities are yielding 4.75%. The market rate of return onequitiesis 8.25%.They are currently using several old-style machinesthat together had cost $700,000. Depreciation of $220,000 hasalready been charged against this total cost; depreciation chargesare $80,000 annually. Management believes these machines will needto be replaced after eight more years. They have a current marketvalue of $205,000.The old machines require eleven workers per shiftearning $14.50/hr plus three maintenance workers paid $13.50/hr.The plant operates day and afternoon shifts five days each week;maintenance workers are assigned to the afternoon shift only.Maintenance expenses have been running at $5,500 annually; the costof electricity has been $26,000 per year. The production process isnot only labor intensive, but also physically demanding. Workplaceinjuries are not uncommon and lately medical claims have beenincreasing.The Machine Tool Division is considering the purchaseof a piece of highly-automated, robotic production equipment. Itwould replace older machines and would offer improvements inquality, and some additional capacity for expansion. Because of themagnitude of the proposed expenditure, a careful estimate of theprojects costs and benefits is needed.The new machine will have a total cost that includesshipping, installation and testing of $1.5 million. The plant willalso need $350,000 in modifications to accommodate the new machine.These costs willbe capitalized and depreciated over the eight-year estimated lifeof the machine. The new machine would require only two skilledoperators (one per shift) who would earn $25/hr. Maintenance willbe outsourced and cost $90,000 per year. The annual cost ofelectricity is estimated to be $50,000.Certain aspects of the decision are difficult toquantify. The most obvious is that Management’s relationship withthe union hasn’t always been a smooth one and union leadership maynot agree to the layoff of the redundant workers. Reassigning themto positions in other divisions might be easierbut there arecurrently only a handful of suitable openings, some of which arenot in the collective bargaining unit.The specs on the new machine indicate that even higherlevels of product quality and lower scrap ratesare possible. Inlight of ever-increasing competition, this might prove to be ofenormous competitiveadvantage. The new machine has a maximum capacity 27% higher thanthe old semi-automated machines which are currently operating at90% capacity.Assignment Parts:a. Calculate the firm’s Weighted Average Cost of Capital.b. Identify and analyze the relevant cash flows forthe two alternatives - buying the new machine vs. continuing to usethe old ones.c. List and describe briefly any areas of uncertaintyor concern for this project. What effect mightthey have? Bullet points are just fine.d. Based on your results in parts b & c, explainwhy you would or would not proceed with the newmachine.