Reference no: EM133120758

Part A

Since its inception, Eco Plastics Company has been revolutionizing plastic and trying to do its part to save the environment. Eco's founder, Marion Cosby, developed a biodegradable plastic that her company is marketing to manufacturing companies throughout the southeastern United States. After operating as a private company for six years, Eco went public in 2017 and is listed on the Nasdaq stock exchange.

As the chief financial officer of a young company with lots of investment opportunities, Eco's CFO closely monitors the firm's cost of capital. The CFO keeps tabs on each of the individual costs of Eco's three main financing sources: long-term debt, preferred stock, and common stock. The target capital structure for ECO is given by the weights in the following table:

At the present time, Eco can raise debt by selling 20-year bonds with a $1,000 par value and a 10.5% annual coupon interest rate. Eco's corporate tax rate is 40%, and its bonds generally require an average discount of $45 per bond and flotation costs of $32 per bond when being sold. Eco's outstanding preferred stock pays a 9% dividend and has a $95-per-share par value. The cost of issuing and selling additional preferred stock is expected to be $7 per share. Because Eco is a young firm that requires lots of cash to grow it does not currently pay a dividend to common stock holders. To track the cost of common stock the CFO uses the capital asset pricing model (CAPM). The CFO and the firm's investment advisors believe that the appropriate risk-free rate is 4% and that the market's expected return equals 13%. Using data from 2017 through 2020, Eco's CFO estimates the firm's beta to be 1.3.

Although Eco's current target capital structure includes 20% preferred stock, the company is considering using debt financing to retire the outstanding preferred stock, thus shifting their target capital structure to 50% long-term debt and 50% common stock. If Eco shifts its capital mix from preferred stock to debt, its financial advisors expect its beta to increase to 1.5

Question

a) Calculate Eco's current after-tax cost of long-term debt.

b) Calculate Eco's current cost of preferred stock.

c) Calculate Eco's current cost of common stock.

d) Calculate Eco's current weighted average cost capital. 

e)  (1) Assuming that the debt financing costs do not change, what effect would a shift to a more highly leveraged capital structure consisting of 50% long-term debt, 0% preferred stock, and 50% common stock have on the risk premium for Eco's common stock? What would be Eco's new cost of common equity?

(2) What would be Eco's new weighted average cost of capital?

(3) Which capital structure-the original one or this one-seems better? Why?

Part B

Eco Plastics Company is currently considering two new projects for investment. The chief financial officer (CFO), has estimated cash flows for two proposed projects. Project L involves adding a new item to the firm's ignition system line; it would take some time to build up the market for this product, so the cash inflows would increase over time. Project S involves an add-on to an existing line, and its cash flows would decrease over time. Both projects have 3-year lives because Eco Plastics Company is planning to introduce entirely new models after 3 years. Here are the projects' net cash flows (in thousands of dollars):

Depreciation, salvage values, net working capital requirements, and tax effects are all included in these cash flows. 

The CFO also made subjective risk assessments of each project, and he concluded that both projects have risk characteristics that are similar to the firm's average project. The CFO has decided to use the lower Weighted Average Cost of Capital (WACC) that was estimated in Part-A as the discount rate for these investments. 

Question

a) Calculate Each Project's NPV. According to NPV, which project(s) should be accepted if they are independent? Mutually exclusive? 

b) Calculate Each Project's IRR. According to IRR, which project(s) should be accepted if they are independent? Mutually exclusive? 

c) Calculate Each Project's MIRR. According to IRR, which project(s) should be accepted if they are independent? Mutually exclusive? 

d) Find the paybacks for Projects L and S. According to the payback criterion, which project(s) should be accepted if the firm's maximum acceptable payback is 2 years, if Projects L and S are independent? If Projects L and S are mutually exclusive? 

e) Find the discounted paybacks for Projects L and S. According to the payback criterion, which project(s) should be accepted if the firm's maximum acceptable payback is 2 years, if Projects L and S are independent? If Projects L and S are mutually exclusive? 

f) Among NPV, IRR, MIRR, Payback and Discounted Payback, which methods do consider the best for evaluating investment? Why