Reference no: EM132186872

Cost of Capital

Information from McCormick

1. As of today, McCormick's market capitalization (E) is $14,237,510,000. Market value of equity (E), also known as market cap, is calculated using the following equation: Market Cap = Share Price x Shares Outstanding.

2. McCormick's book value of debt is $3,237,150,000. Book value of debt (D) is calculated as follows: Book Value of Debt = Last Two-Year Average of Current Portion of Long-Term Debt + Last Two-Year Average of Long-Term Debt & Capital Lease Obligation.

3. Cost of Equity = Risk-Free Rate of Return + Beta of Asset x (Expected Return of the Market - Risk-Free Rate of Return)
Risk-free rate of return = 2.82 percent.
Beta = 0.30.
Market premium = (Expected Return of the Market - Risk-Free Rate of Return) = 6 percent

4. Cost of Debt = Last Fiscal Year End Interest Expense / Book Value of Debt (D). McCormick's last fiscal year end interest expense is $95.7 million.

5. Use the effective tax rate of 25.705 percent.

Questions

1. Find the weight of equity = E / (E + D).
2. Find the weight of debt = D / (E + D).
3. Find the cost of equity.
4. Find the cost of debt.
5. Find the weighted average cost of capital (WACC).

Capital Budgeting

Details of McCormick Plant Proposal

McCormick& Company is considering a project that requires an initial investment of $24 million to build a new plant and purchase equipment. The investment will be depreciated as a modified accelerated cost recovery system (MACRS) seven-year class asset. The new plant will be built on some of the company's land, which has a current, after-tax market value of $4.3 million.

The company will produce bulk units at a cost of $130 each and will sell them for $420 each. There are annual fixed costs of $500 thousand. Unit sales are expected to be 150,000 each year for the next six years, at which time the project will be abandoned. At that time, the plant and equipment is expected to be worth $8 million (before tax) and the land is expected to be worth $5.4 million (after tax).

To supplement the production process, the company will need to purchase $1 million worth of inventory. That inventory will be depleted during the final year of the project. The company has $100 million of debt outstanding with a yield to maturity of 8 percent, and has $150 million of equity outstanding with a beta of 0.9. The expected market return is 13 percent, and the risk-free rate is 5 percent. The company's marginal tax rate is 40 percent.

Should the project be accepted?

Questions

1. What will be the tax depreciation each year?

2. What will be the value of the plant and equipment for tax purposes in year six? Will it be sold for a gain or a loss, and what will the tax effect be?

3. What is the weighted average cost of capital (WACC)?

4. What is the salvage cash flow of the new equipment? Include the income tax effect.
5. What is the total operating cash flows, given the following operating cash flows:

6. Create an after-tax cash flow timeline.
7. What are the total expected cash flows at the end of year six? The $4.3 million is an opportunity cost and must be included at date 0 as a cash outflow. If the project is accepted, however, the land can be sold in six years for $5.4 million.

8. Find the NPV using the after-tax WACC as the discount rate.
9. Find the IRR.

10. Should the project be accepted? Discuss whether NPV or IRR creates the best decision rule.

Attachment:- Workbook.rar