Question

Tata Corp. needs to purchase new plastic moulding machines to meet the demand for its product. The cost of the equipment is $8,927,000. It is estimated that the firm will increase after tax cash flow (ATCF) by $1,894,864 annually for the next 3 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 1.71, the risk free rate is 1.88% and the expected market return is 7.65%. Tata Corp.'s semi-annual bonds have 8.10% coupons, 25 years to maturity, and a quoted price of 108.410. Assume the firm's tax rate is 34%. The firm's last 5 dividends (the last in the list is D0) are 1.23, 1.56, 1.67, 2.17, and 2.72. Its current market price is $162.71.
1. What is Tata Corp.'s historic rate of dividend growth based on the last 5 dividends?
2. What is the firm's required return on equity based on the DDM model?
3. What is the firm's required return in equity based on the CAPM?
4. What is the firm's after-tax cost of debt?
5. What is the firm's WACC?
Short Answer A : Should the firm purchase the new equipment? (hint: you will need to make an additional calculation.)
Short Answer B: In calculating the firm's WACC, you had to make a couple of judgment calls. What were they and briefly discuss why you made the decisions you did.
Short Answer C: Assume that there are some large cleanup and disposal costs of $892,700 at the end of the project (in year 4). Explain in a sentence or two how this impacts the calculation of the internal rate of return? Note that no additional calculation is required to answer this question.
Short Answer D: Briefly explain which decision rule is best when trying to make a capital budget decision in this scenario where there are cleanup costs at the end of the project.
Short Answer E: Tata Corp. is changing its capital structure (target debt to equity ratio). In calculating WACC, we assume this only changes the weights used in the calculation. What else might change in the WACC calculation, why would it change, and what factors would influence this?

Answer 1

1]

Dividend now = dividend 5 years ago * (1 + growth rate)5

$2.72 = $1.23 * (1 + growth rate)5

growth rate = ($2.72 / $1.23)1/5 - 1

growth rate = 17.20%

2]

required return = (current dividend * (1 + growth rate) / current market price) + growth rate

required return = ($2.72 * (1 + 17.20%) / $162.71) + 17.20%

required return = 19.16%

3]

required return = risk free rate + (beta * (expected market return - risk free rate))

required return = 1.88% + (1.71 * (7.65% - 1.88%))

required return = 11.75%

4]

after tax cost of debt = YTM of bond * (1 - tax rate)

YTM is calculated using RATE function in Excel with these inputs :

nper = 25*2 (25 years to maturity with 2 semiannual coupon payments each year)

pmt = 100 * 8.1% / 2 (semiannual coupon payment = face value * annual coupon rate / 2. This is a positive figure as it is an inflow to the bondholder)

pv = -108.41 (current bond price. This is a negative figure as it is an outflow to the buyer of the bond)

fv = 100 (face value of the bond receivable on maturity. This is a positive figure as it is an inflow to the bondholder)

The RATE calculated is the semiannual YTM. To calculate the annual YTM, we multiply by 2. Annual YTM is 7.36%

after tax cost of debt = YTM * (1 - tax rate)

after tax cost of debt = 7.36% * (1 - 34%) ==> 4.86%

5]

WACC = (weight of debt * cost of debt) + (weight of equity * cost of equity)

The weights of debt and equity are taken based on the target capital structure, since it wants to quickly change its debt to equity ratio to 1.5.

Debt equity ratio = 1.5

Weight of debt = 1.5 / (1 + 1.5) = 1.5 / 2.5 = 0.6

Weight of equity = 1 / (1 + 1.5) = 1 / 2.5 = 0.4

cost of equity = average of DDM and CAPM methods = (19.16% + 11.75%) / 2 = 15.45%

WACC = (weight of debt * cost of debt) + (weight of equity * cost of equity)

WACC = (0.6 * 4.86%) + (0.4 * 15.45%)

WACC = 9.10%