$150,000 Per Year, but Would Also Increase Operating Costs by $80,000 Per Year. A

Question 1:

Your boss, the president of Parts R Us (headquartered in Hot Springs Arkansas), has asked you to evaluate the proposed replacement of the firm's chicken part homogenator. The new machine would cost $400,000 including freight and installation, and would qualify for depreciation allowances under 3-year MACRS (0.33, 0.45, 0.15, .07). The purchase of this machine would increase before tax revenuesby

$150,000 per year, but would also increase operating costs by $80,000 per year. A

$30,000 increase in chicken parts inventory would be required if the new machine is purchased. Finally, it would have an economic life of 4 years, after which there would be a $25,000 charge for disposing of the, by then, toxic equipment.

The old machine was purchased 2 years ago for $350,000, but could continue to be used for another 4 years at the end of which time it would have a salvage value of

$35,000. Depreciation for this machine is computed by 3-year MACRS. You have learned from Jim Bob, the local dealer in parts processing equipment, that the old homogenator could be sold right away for $150,000.

The firm's marginal tax rate is 34 percent, and the project's cost of capital is 10 percent.

Compute the project's Net Present Value and Internal Rate of Return, showing all intermediate computations.

Question 2:

a)Sandusky Corporation has hired you to investigate the weighted average cost of capital (WACC) that the firm would face at different capital expenditure levels over the coming year. After some investigation, you have gathered the following information:

Sandusky’s target capital structure is 60 percent equity and 40 percentdebt.

The first $3 million of equity funding can be obtained internally using retained earnings. After that, new common stock will be sold at an estimated priceof

$50 per share. The firm’s most recent dividend was $2.50 per share and dividends are expected to grow at a rate of 5 percent per year. The firm will incur a flotation cost of $5 per share for any new shares sold.

Sandusky can issue $3.5 million in new bonds with a before tax cost of 6.5 percent (including flotation costs). Any additional debt would have a before tax cost of 8percent.

The firm’s tax rate is 34percent.

Construct a labeled graph showing the weighted average cost of capital faced by the firm. Be sure to show all intermediate calculations.

b)Assume that the most important capital spending project that Sandusky hasunder consideration is the acquisition of a smaller, rival firm, for a cost of $10 million. The internal rate of return for this project has been estimated as 9 percent. Using the information from the first part of this question, determine whether the proposed acquisition should go forward. Be sure to support your recommendation with an explanation.

Question 3:

Your firm currently has total assets of $100 million, $40 million of which are funded by 8 percent annual coupon bonds selling at par. The rest of the firm’s assets are funded by common stock. For the most recent fiscal year, the firm had sales of $180 million, variable operating costs of $140 million and EBIT of $10 million.

a)If you acquire the firm mentioned in Question 2b, you plan to upgrade key parts of their manufacturing facility in order to improve efficiency and support production of a higher quality product. Acquiring the other firm and implementing these changes will reduce variable operating costs by $7 million, but will increase fixed operating costs by $6 million. In addition, sales will increase by $4 million. What is the degree of operating leverage (DOL) for the combined firm?

b)After looking at other firms in the industry you are inclined to believe that your firm has been using less than the optimal amount of debt. Most competing firms have a lower proportion of fixed operating costs, but you note that all three of the firm’s key competitors have a degree of total leverage (DTL) at or near 6.5. If your firm has reserve borrowing capacity, you would like to use it to fund the $10 million purchase price of the other firm. What is the maximum debt to asset ratio that the firm can support without exceeding a DTL of 6.5?

c)List and briefly explain 3 key determinants of “optimal” capital structure. Why do capital structure choices vary so much from industry to industry?