Reference no: EM1310995

Calculation of After-Tax Cost of Debt

Central Florida Computer Company (CFCC), a leading manufacturer of IBM look-alike computers, is considering the installation of a new production line to manufacture clones of IBM computers. Mike Stoltz, the newest financial analyst, is evaluating the proposal in the spring of 19x0, with anticipated initial investment occurring late in 19x0 and the first revenue arriving at the end of 19x1. The proposed portion of the plant that company owns was identified last year by an outside consultant at a cost of $60,000. At the moment, a portion of this plant is vacant. The 10,500 square feet required for the assembly line represents 25 percent of the entire plant. The plant originally cost $1,450,000 12 years ago and is being depreciated over 20 years. Warehouse space currently leases for $11 per square foot per year, however the company has strict policy forbidding the renting or leasing out of any of its vacant production facilities.

CFCC must spend $1,100,000 on equipment for the line, plus $10,000 in shipping and installation costs. The equipment manufacturer is willing to guarantee these expenses, so CFCC's management is certain of these cash flows. The machines are expected to have a five-year economic life. For tax purposes, they are classified as special manufacturing tools, and hence fall into a three-year MACRS depreciation schedule. (This schedule requires percentage depreciations of 33 percent, 45 percent, 15 percent, and 7 percent for each of the first four years, respectively.)

CFCC's marketing department feels that sales for the division will depend upon the state of the economy. Exhibit 1 details the marketing department's sales estimates.

The marketing department expects that, given the state of economy, unit sales will be flat over the five-year life of the assembly line, but prices, and hence revenues, are expected to increase with inflation by 6 percent per year over the life of the line. The initial selling price in 19x1 is expected to be $1,500 per unit.

The engineering department expects that fixed costs (excluding depreciation) will be constant $70,000 per year and that variable component costs (parts assembled to manufacture the computers) and labour costs will be 45 percent of revenues. The department is virtually certain of both of these estimates. CFCC's marginal tax rate during the period is expected to remain at 38 percent.

The new assembly line will require an increase in the level of CFCC's raw material inventories, finished goods inventory, and accounts receivable. The expected increase in current assets will be somewhat offset by a corresponding increase in current liabilities. The resulting increase in net working capital will require an investment of $30,000 in 19x0 prior to 19x1 sales. Beginning in 19x1, additional annual increases in net working capital will be required; they will vary directly with annual changes in revenue at a rate of 11.25 percent per dollar of marginal revenue. Thus, the change in net working capital in 19x1 will be 11.25 cents per dollar of 19x2 revenue increase over the 19x1 revenue level. All of the working capital investments will be recoverable at the end of project's life.

At the end of the line's operating life, the line will be closed down. CFCC expects to turn the plant square footage over to another project. The assembly line machinery, on the other hand, will be sold for its estimated salvage value. The engineers have provided the estimates of terminal value before taxes (Exhibit 1).

CFCC's stock is traded on the over-the-counter market at $30 per share, with an estimated beta of 1.5. Analysts expect that the company will pay $2.1 in dividends per share in 19x1; dividends have grown 9 percent annually for the past 10 years. Currently, Treasury securities yield 7 percent and the Standard and Poor's 500 Index is expected to return 12.5 percent annually for the next several years. CFCC borrows from a local bank at 11 percent.

CFCC's operating committee has always maintained the company's book value capital structure at what it believes is the company's optimal or target capital structure. Exhibit 2 provides the company's current capital structure.

EXHIBIT 1			Exhibit 2
Central Florida Computer Company
Forecasts of Sales and Terminal Value
State of Economy	Probability	sales(units)	Terminal Value (Selling Price)
Recession	0.35	300	$100,000
Slow growth	0.4	400	400,000
Strong growth	0.25	500	900,000

 

Central Florida Computer Company
Capital Structure
Source	Amount
Long-term debt	$3,500,000
Capital stock paid in	1,000,000
Retained earnings	4,000,000

1. Compute the company's current cost of capital. Assuming that this project has the same risk characteristics as the company's "average" project, estimate the projected cash flows and calculate the expected net present value, profitability index, internal rate of return, modified internal rate of return, payback period, and accounting rate of return. Would you recommend the project? Why or why not?