Exercises COST OF CAPITAL Bemie Dy, the newly-hired financial analyst of Pioneer, Inc. wants to determine the cost of equity of Pioneer which he will use for determining the feasibility of the new project the company is planning to undertake. So far, he has gathered the following information: Average treasury bill rate 5% Market risk premium 0% Beta ofa listed company which approximates Pioneer’s operations 0.80 REQUIRED: Determine Pioneer's cost of equity. Consolidated Resources Corp. has the following capital structure which is considered optimal: Debt (16%) P 1,050,000,000 Preferred stock (13.5%, P100 par) 450,000,000 Common stock (PI par) 000,000,000 Total P-2,500,000,000 ‘The company’s shares are selling at P1.80 per share. A cash dividend of PO.10 per share is expected to be distributed in a year’s time, If the company were to issue additional common shares to the public, transaction cost amounting to 5% of the issue price will be incurred. Corporate tax rate is 36%. REQUIRED: 1) Determine the cost of issuing new shares assuming an average annual growth rate in dividends of 12%. b) If the company were to raise P500 million using a mix based on the existing capital structure, determine the marginal cost of capital assuming the following: (1) the preferred shares will be issued at par and at a flotation cost ‘of P7.50 per share; (2) additional loans will have an interest of 16%.Maharlika Resources Amalgamated, Inc. (MRAI) has the following capital structure as of December 31, 1996: Debt (15%) P_ 350,000,000 Preferred stock (12.5%, P100 par) 200,000,000 Common stock (PI par) 300,000,000 Retained earnings 150,000,000 Total P1,000,000,000 For 1997, the company is expected to generate a net income of P140 million, 50% of which will be distributed as cash dividends. ‘The company’s earnings is expected to have an annual growth rate of 10%. Corporate tax rate is 36%. Maharlika’s shares are trading at P2.30 per share. Transaction costs of 5% of the issue price will be incurred if new shares, both preferred and common shares, were to be issued. Preferred shares will most likely be issued at par if the company decides to issue additional shares. New borrowings will be charged an interest of 16%. For 1997, the company is allocating P200 million for expansion. REQUIRED: 2)’ Assuming the present capital structure is optimal, what level of capital expenditures must be reached before the company needs to sell new shares? b) Determine the marginal cost of capital assuming the company meets its equity requirements only with the addition to retained earnings. ©) Ifthe company were to raise P200 million, determine the marginal weighted average cost of capital.Exercises Capital Budgeting 1. MCO Manufacturing Co. acquired a new machine for PHP4.5 million, including installation cost. Expected additional cash flows that will be generated for the business as a result of acquiring this machine, net of taxes, are as follows: Year 1 PHP1,500,000 Year 2 2,000,000 Year 3 2,500,000 Year 4 2,500,000 ‘Year 5 2,500,000 ‘The company’s cost of capital is 10%. ‘Compute the following: a b c. payback period internal rate of return (IRR) net present value (NPV) 2, The Pacific Products Corporation is considering to mechanize some aspects of its manufacturing operations which.are currently done manually. Mechanization will reduce variable costs of production and standardize product quality to reduce rejects/defects. The proposal submitted by the manufacturing department contains the following information. a Machinery and equipment will cost PHP10 million, Installation and testing will cost another PHP500,000. ‘The machine has a useful life of 10 years and the company uses straight line depreciation. Some old equipment will be rendered redundant by the new machines. They have a book value of PHP1,000,000 and can be sold for half the value. The old equipment has a remaining useful life of 10 years. ‘The machinery and equipment will be placed in an area of the plant that is currently being leased out to another company at annual rent of PHPS00,000 payable at the end of each year. ‘The new machinery and equipment will require an inventory of spare parts and supplies of PHP350,000 since the parts have no local distributors. For purposes of computing the annual cash flows, assume that the spare parts are used uniformly throughout the life of the machine,€. The employees displaced by the machine will be given termination benefits of PHP12 million. Termination’ benefits are tax-deductible expenses. Their termination will reduce annual payroll costs by PHP6 million per year. £. Reduced rejects/defects will yield savings of PHP1.S million per year. &. Fuel, power, repairs and other operating costs of the new equipment will be PHP800,000 per year. h. The company’s tax rate is 30% and the required rate of return for cost-cutting projects is 15%. Compute the following: a) Initial outlay b) Annual cash flow ©) Net present value 3, ASC Realty Company is planning to put a mall in Pampanga, Below are the estimated costs of the mall: Particulars Cost Expected Disbursement |. H Date’ Land. 100,600,000 Year 0 Mall 400,000,000 Year 0 Mali 800,000,000 Year 1 Working capital _ 160,000,000 Year 1 Expected earnings before depreciation and taxes are as follows: i ‘Amount Year 2 170,000,000 (Year3 a 220,000,000 Year 4 rae 70,000,000 Year 5 320,000,000 [Near 6— Year 21 370,000,000 The mall is going to be depreciated over 20 years using the straight line method of depreciation, Land is expected to be worth PHPS00 million in Year 21 Corporate tax rate is 30%. Cost of capital is 15%. For the sale of the land, a 6% capital gains tax based on the gross selling price is to be applied.Requirement: Determine if the mall is financially feasible. 4, Redo Exercise Number 3 with the cost of mall increasing to PHP| billion in Year } from PHP 800 million. ‘This means that the total cost of the mall has now incteased to PHP1.4 billion 5, Redo Exercise Number 3, with the cost of capital increasing from 15% to 16%. The chief executive officer of a consumer-based company is considering the expansion of one of its product lines. “The estimated cost of the expansion is PHP65 million broken down as follows: plant, property and equipment, PHP50 million; working capital, PHP1S million. ‘The fixed assets will be depreciated over a five-year period using the straight line method of depreciation. If the ‘company were to implement the project, PHP30 million will be spent immediately while the remaining PHP3S million will be spent a year later. The product is being sold at PHP2S/unit with an estimated variable cost of PHP18/unit. Incremental fixed operating expenses is about PHP10 million per year, in addition to the annual depreciation of fixed assets. The company’s cost of capital is 10% and its tax rate is 40%. Incremental sales in units are as follows: Yyr.2 Yr.3 Yr4 Yes Yr.6 4,000,000 4,000,000 5,000,000 5,000,000 6,000,000 a. Assuming sales are based on cash, what is the expansion’s NPV? b. If sales fall short of the targets and only the following sales in volume are tealized, re-compute the project’s NPV. Yr.2 yr.3 Yr4 Yr.5 Yr. 6 3,000,000 3,000,000 4,000,000 5,000,000 5,000,000 What if sales are realized as projected, but the variable cost increased from PHP18/unit to PHP20/unit, recompute the project’s NPV. 7, A company wants to introduce a new product using some ofits plant facilites * idle capacity. ‘The value-of these idle facilities is estimated at PHP25 million, The following information are made available: 394,202 S856 Ng 422‘The company has to invest additional PS million to modify the existing plant facilities depreviable over the remaining useful life of the other facilities of 10 years, ‘a, A warehouse which is being leased out at PHP150,000 per year will be used to store the finished goods for the new product. b. . Additional investment in working capital worth PHP2 million has to be made. c. _ Estimated revenues from the new product are as follows: Year 1 PHP 25,000,000 Year 2 30,000,000 Year 3 35,000,000 Year 4-10 40,000,000 4. Contribution margin is 20%. Other incremental fixed operating cash expense is about PHP? million a year. e: Tax rate is 30%. f, Fixed assets are depreciated using the straight line method. 8 Cost of capital is 20%. Should the new product be introduced? Support your answer. 8. A project with a 3-year life has an NPV of PHP7.6 million with a cost of capital ‘of 25%, The projected cash flows from the project are as follows: Year! PHP 15,000,000 Year2 20,000,000 Year 3 25,000,000 If realization of net cash inflows is delayed by a year, but not the cost, by how much will the NPV change? Pete