Question

Question 3: Coca-Cola Corp. needs to purchase new plastic moulding machines to meet the demand for its product. The cost of the equipment is $3,028,000. It is estimated that the firm will increase after tax cash flow (ATCF) by $611,671 annually for the next 5 years. The firm is financed with 40% debt and 60% equity, both based on current market values, though the firm has announced that it wants to quickly change its debt to equity ratio to 1.5. The firm's beta is 1.24, the risk free rate is 3.82% and the expected market return is 7.23%. Coca-Cola Corp.'s semi-annual bonds have 11.80% coupons, 22 years to maturity, and a quoted price of 91.547. Assume the firm's tax rate is 34%. The firm's last 5 dividends (the last in the list is D0) are 1.23, 1.60, 2.04, 2.51, and 2.87. Its current market price is $107.06.

Question 3, Math E: What is the firm's WACC?

Question 3, Math F, Short Answer A: Should the firm purchase the new equipment? Justify your answer based on what you have learned in the course (hint: you will need to make an additional calculation.)

Answer 1

Math E. The weighted average cost of capital is 8.05%

EXPLANATIONS:-

For the calculation of WACC we have to find the following:

a. Cost of Equity

the formula for cost of equity under CAPM model is

Where,

= Cost of Equity

= Risk-Free Rate

=Expected Return On The Market Portfolio

= Beta coefficient for the company

Here,

= 3.82%

=7.23%

= 1.24

= 3.82+ 1.24( 7.23-3.82)

   = 8.04%

Cost of Equity = 8.04%

b. Cost Of debt

  cost of debt of bond is yield to maturity (YTM)

The formula for YTM = (C+ ((P-M) / n)) / ((p+m) / 2)

Here,

C (coupon interest) = Coupon rate * Par value = 11.80% * $100 = $11.8

P (Par Value ) = $100

M (Market Price) = $91.547

n (years to maturity) = 22 years

Tax rate = 34% or .34

By applying values into the formula we get,

YTM = ($11.8 + (($100 - $91.547) / 22)) / (($100 + $91.547) / 2)

YTM = ($11.8 + $.35491666) / $97.8705

YTM = 0.1242 or 12.42%

Cost Of debt = 12.42%

Marginal tax rate (t)	34% or .34
Weight of debt	=.4
Weight of capital	=.6
cost of equity	= 8.04%
cost of debt	=12.42%
After tax cost of debt	= YTM * (1-t)
	= 12.42 * (1-.35)
	=8.073%
WACC	=
	=.(.4* 8.073%) + (.6 * 8.04%)
	=8.05%

NOTE:- The existing weight of 40% and 60% is used for calculating WACC because the new ratio of 1.5 is just announced and not implemented until now.

Q.2

The decision regarding the capital investment in new equipment can be made by calculating and analyzing capital investment analysis tools nlile NPV , IRR etc.

the NPV of the new equipment is calculated as follows:-

Discounted cash flow calculation

	year 1	year 2	year 3	year 4	year 5
After-Tax cash flows	$611,671	$611,671	$611,671	$611,671	$611,671
PV of $1 Factor for 8.05%(WACC)	.9255	.8566	.7927	.7337	.679
Discounted Cash Flow	$566101.5	$523957.4	$484871.6	$448783	$415324.6

NPV = PV of future expected net cash inflows – initial investment

PV of future expected net cash inflows = $2439038 ($566101.5+$523957.4+$484871.6+$448783+$415324.6)

Initial investment = $3,028,000

NPV = $2439038 - $3,028,000

NPV = -588962

Here the NPV of the new equipment is showing a negative value of -588962 dollars. which means that the present value of the future cash flows from the new equipment is less than that of the investment in the equipment. Therefore the new equipment will not be a profitable project and it should not be purchased by the company.