You have always been told that the cost of capital for ClarkUpholstery is 9%, so you started to evaluate the two alternatives(renew or replace) using the 9% cost of capital. However, itoccurred to you that you have never calculated the cost of capitaland you are not sure the last time some else may have calculatedthe cost of capital. Therefore, before you go any further in theprocess of evaluating the two alternatives you decide to calculatethe cost of capital using the firm’s current capital structure andcurrent yields on long term debt and equity. To make thecalculation you know you need the balance sheet to determine thecapital structure. Clark Upholstery’s current balance sheet is asfollows:

Current Assets $75,000 Current Liabilities $25,000

Fixed Assets Long Term Debt (12%) $150,000

Land $100,000 Equity

Equipment 150,000 Common Stock $50,000

Total Fixed Assets $250,000 Retained Earnings 100,000

Total Equity $150,000

Total Assets $325,000 Total Liab & Equity $325,000

You will use the balance sheet to determine the relative weightof debt vs equity in your long-term capital structure. You alsoknow that you must determine the current yield/value on your debtand equity in order to determine the after-tax cost of both debtand equity. Having both the relative weights of your capitalstructure and after-tax rates you can then determine your WeightedAverage Cost of Capital (WACC), which you will use to evaluate thetwo alternatives (renew vs replace).

Your outstanding long-term bonds have a 12% coupon rate, but areselling at a discount on the publicly traded market. The currentprice is $88, that is $880 for a $1,000 face value bond. You needto determine the current yield/value of the current long-term debt.You are considering selling more bonds in the public market tofinance the cost of the renewal or replacement. If you do this yourinvestment banker is telling you that a 20-year bond would need acoupon rate of 13.6%, and to be sold Clark Upholstery would incur a$45 per bond discount and flotation costs of $32 per bond. Usingthis information, you calculate the cost of your current long-termbonds and also the cost if you sell $100,000 additional long-termbonds to finance the investment.

The other portion of your capital structure is your equity,which is comprised of Common Stock and Retained Earnings. Yourstock is not publicly traded, so you decide to use the CapitalAsset Pricing Model

(CAPM) to determine the cost of equity. To calculate the CAPMyou need risk free rate (which you determine to be 4%) and also themarkets expected return for the stock of companies like Clark(15%). Using historical information about Clark and also about thefurniture Upholstery industry you determine that the firm’s beta is0.88. You use this information to determine the equity cost of bothCommon Stock and Retained earnings.

Finally, you combine the debt and equity cost with the weightsof debt and equity to determine Weighted Average Cost of Capital(WACC) assuming that Clark will finance the investment using thecurrent mix of debt and use retained earnings (so no new equity issold). You will also calculate the WACC assuming that Clark willfinance $100,000 of the investment by issuing new bonds. YourInvestment Banker advises you that taking on $100,000 of newlong-term bonds will increase your Beta from 0.88 to 1.1.

You now have two WACC, one for the current capital structure andone that assumes the investment is financed by $100,000 of newlong-term bonds and the balance being funded by Retained Earnings.You will use both WACC to evaluate the two investment alternative(renew or replace).

Now that you have all the calculations of incremental after-taxcash flow and WACC you are ready to evaluate the alternatives. Todo this you decide to calculate all the classic evaluation methods,Payback Period, PV and its related Profitability Index and InternalRate of Return. You have also heard about Modified Internal Rate ofReturn (MIRR) and aren’t sure if you will need/use it, but you willcalculate it just in case. The company is concerned about aneconomic downturn in the near future which could throw off therevenue projections, and therefore has established a 4-year paybackperiod as a pre-qualification for any new investments. You will nowcomplete your project evaluation and do an accept/rejectdetermination and a ranking for the two alternatives at bothWACC.

Alt 1 Alt 2

26300   50100
36000   65200
35980   39420
43460   16340
33460   15940
1800   2200