Question

Acme Manufacturing, Inc. was originally a family owned operation that has been in business for several generations. It has grown steadily and is now listed on the stock exchange with family members still owning a substantial portion of the shares. Over the years, the company has acquired a reputation for exceptional quality and has won awards from major customers.
The firm is 75% equity financed; shares currently trade at $37 and do not pay a dividend. Debt capital is provided by a single issue of bonds (20 year, $1,000 par value, $85 coupon) currently trading at $1,094. The firm’s beta is 1.25. Their traditional hurdle rate has been 12%, though the rate has not been reviewed in many years. Over the years, shareholders have come to expect a 10% return. Their corporate tax rate is 25%. Treasury securities are yielding 4.75%. The market rate of return on equities is 8.25%.
They are currently using several old-style machines that together had cost $700,000. Depreciation of $220,000 has already been charged against this total cost; depreciation charges are $80,000 annually. Management believes these machines will need to be replaced after eight more years. They have a current market value of $205,000.
The old machines require eleven workers per shift earning $14.50/hr plus three maintenance workers paid $13.50/hr. The plant operates day and afternoon shifts five days each week; maintenance workers are assigned to the afternoon shift only. Maintenance expenses have been running at $5,500 annually; the cost of electricity has been $26,000 per year. The production process is not only labor intensive, but also physically demanding. Workplace injuries are not uncommon and lately medical claims have been increasing.
The Machine Tool Division is considering the purchase of a piece of highly-automated, robotic production equipment. It would replace older machines and would offer improvements in quality, and some additional capacity for expansion. Because of the magnitude of the proposed expenditure, a careful estimate of the projects costs and benefits is needed. The new machine will have a total cost that includes shipping, installation and testing of $1.5 million. The plant will also need $350,000 in modifications to accommodate the new machine. These costs will be capitalized and depreciated over the eight-year estimated life of the machine. The new machine would require only two skilled operators (one per shift) who would earn $25/hr. Maintenance will be outsourced and cost $90,000 per year. The annual cost of electricity is estimated to be $50,000. Certain aspects of the decision are difficult to quantify. The most obvious is that Management’s relationship with the union hasn’t always been a smooth one and union leadership may not agree to the layoff of the redundant workers. Reassigning them to positions in other divisions might be easier
but there are currently only a handful of suitable openings, some of which are not in the collective bargaining unit.
The specs on the new machine indicate that even higher levels of product quality and lower scrap rates are possible. In light of ever-increasing competition, this might prove to be of enormous competitive advantage. The new machine has a maximum capacity 27% higher than the old semi-automated machines which are currently operating at 90% capacity.
Assignment Parts:
a. Calculate the firm’s Weighted Average Cost of Capital.
b. Identify and analyze the relevant cash flows for the two alternatives - buying the new machine vs. continuing to use the old ones.

Answer 1

	a.	Calculation of the firm’s Weighted Average Cost of Capital.
	Wd	Weight of debt	0.25	(1-0.75)
	Pv	Current Price of bond	$1,094
	Pmt	Annual coupon payment	$85
	Nper	Number of years of coupon payment	20
	Fv	Payment at maturity=Face value	$1,000
	RATE	Yield to maturity	7.57%	(Using RATE function of excel with Nper=20, Pmt=$85, Pv=-1094,Fv=1000)
	T	Corporate Tax Rate=25%	0.25
	Cd=RATE*(1-T)	Cost of Debt	5.68%
	We	Weight of Equity	0.75
		Expected Return on stock
		Rf+Beta*(Rm-Rf)
		Rf=Risk free return=4.75%
		Beta=1.25
		Rm=market Return=8.25%
		Expected Return on stock=4.75+1.25*(8.25-4.75)	9.125
		Expected Stock return=	9.125%
	Ce	Cost of Capital	9.125%
		Weighted Average Cost of Capital(WACC)=Wd*Cd+We*Ce
		Weighted Average Cost of Capital(WACC)	8.26%
		Relevant cash flows for the two alternatives
		Continuing with Old machine:
		Operating Costs:
		Machine workers pay	$663,520	(11*2*8*5*52*$14.5)
		Maintenance workers pay	$84,240	(3*8*5*52*$13.5)
		Maintenance expense	$5,500
		Electricity expenses	$26,000
		Depreciation tax shield	$20,000	(80000*0.25)
		Purchase of New MachineNew Machine
		Current market value of old machine	$205,000
		Accumulated Depreciation	$220,000
		Purchase price	$700,000
		Current Book value	$480,000
		Loss on disposal	$275,000
		Tax saving on disposal	$68,750	(275000*0.25)
		After Tax cash flow on disposal	$273,750
		Cost of new machine	$1,500,000
		Modification costs	$350,000
		Total capitalized cost	$1,850,000
		Less cash flow from selling old machine	$273,750
		Net InitialCash flow	$1,576,250
		Operating costs;
		Annual Depreciation Tax shield (1850000/8)*0.25	$57,813
		Cost of skilled operator	$104,000	(2*8*5*52*$25)
		Maintenance expenses	$90,000
		Cost of electricity	$50,000