Question

Reckitt Benckiser Group plc is a British consumer goods company. It is considering the replacement of one of its existing machines with a new model. The existing machine can be sold now for £8,000. The new machine costs £50,000 and will generate free cash flows of £11,416.55 p.a. over the next 6 years. The corporate tax rate is 35%. The new machine has average risk. Reckitt Benckiser’s debt-equity ratio is 0.5 and it plans to maintain a constant debt-equity ratio. Reckitt Benckiser’s beforetax cost of debt is 5.85% and its cost of equity is 13.10%.

a) Compute Reckitt Benckiser’s weighted average cost of capital.


b) What is the NPV of the new machine and should Reckitt Benckiser replace the old machine with the new one?

c) The average debt-to-value ratio in the pharmaceutical industry is 20%. What would Reckitt Benckiser’s cost of equity be if it took on the average amount of debt of its industry at a cost of debt of 5%? Do this calculation assuming the company does not pay taxes.


d) Given the capital structure change in question c), Modigliani and Miller would argue that according to their theory, Reckitt Benckiser’s WACC should decline because its cost of equity capital has declined. Discuss.

Answer 1

a) Computation of Reckitt Benckiser’s weighted average cost of capital

WACC=(Wt.d*kd*(1-Tax rate))+(wt.e*ke)

ie.(0.5/1.5*5.85%*(1-35%))+(1/1.5*13.10%)=

10.00%

b)NPV of the new machine at the above WACC, 10%

NPV=Initial Investment+Cash flow from sal eof old m/c+PV of 6 yrs.' FCFs of the new m/c

ie. -50000+8000+(11416.55*4.35526)=                 P/A,i=10%; n=6=4.35526

7722.04

YES.Reckitt Benckiser should replace the old machine with the new one, as the NPV of the replacement decision is POSITIVE & will add value to the firm.

c.Assuming the company does not pay taxes, for the given capital structure changes,

we need to find the unlevered cost of equity, r0

By MM Proposition II with Taxes :

ke=r0+(D/E*(1−tax rate)*(r0−rd))

i.e 13.10% = r0 +( (0.5/1)*(1-0.35)*(r0-5.85%))

11.3217%

Now , as per MM Proposition II without Taxes , cost of equity for the new level of debt,20% =

ke = UnL cost of equity as above+(D/E*(UnL ke−kd))

i.e new ke =11.3217% + ((0.20/0.80)*(11.3217%-5%))

12.90%

So,

Reckitt Benckiser’s cost of equity declined from 13.10% to 12.90%   , when it took on the average amount of debt to value of 20%

d..Now the WACC will be

WACC=(Wt.d*kd)+(wt.e*ke)

WACC = (0.2*5%) +(0.8*12.90%)

11.32%

Debt		Equity		WACC
Wt.	Cost	Wt.	Cost
33.33%	3.80%	66.67%	13.10%	10.00%
20%	5.00%	80%	12.90%	11.32%
1.27%		8.73%		10.00%
1.00%		10.32%		11.32%

M&M proposition II with no taxes , argues, that altering the debt & equity , will only off-set each other & will not lower the WACC.

But here, lowering the debt, WACC has increased from 10% to 11.32%

Seeing the anatomy of the making of the WACC , in both levels of leverage

Here, the decline in cost of equity capital , is more than off-set by its increase in proportion to the total value ,than before.