Reference no: EM132406688

Question 1

The "ABCEasyAs123" Corporation has numerous retail clothing stores in the Lower Mainland. Its tax rate is 40 percent. ABC is going to expand its business by building a new retail store in the Lower Mainland and has retained you as a consultant to determine the appropriate discount rate to use in their NPV calculations. The CEO of ABC, Michael Jackson, has told you that the new retail store will require $10 million and that the firm has enough cash for this project. If the firm had to raise money, bonds with a 12-year maturity (to match the payment frequency and maturity of the current bonds) could be issued at an interest rate of 9 percent. Flotation costs of 5% of face value would be incurred. $100 par value preferred shares that pay a dividend of 8% are currently trading at a 10% discount from their par value. Preferred shares could be sold with after-tax issue costs amounting to 4 percent. Common shares are trading for $20. New common shares could be issued with after-tax flotation costs of 10%. Growth in dividends has been steady at 5 percent per year, and it is assumed that this will continue. The dividend for the current year is expected to be $2.20 per share. ABC has $10,000,000 of bonds outstanding with a coupon of 10% paid semi-annually; 50,000 preferred shares that were issued at $100 par; and, 1,000,000 common shares that were issued at $8.

Calculate the "appropriate" discount rate for ABC.

• Bonds
• Preferred shares
• Common shares

Question 2

A firm's target capital structure is 60 percent debt and 40 percent common equity. The firm's common stock has just paid a dividend of $2 per share. It is expected that the dividends of this firm will grow at a rate of 10 percent per year in the future. The current price of the common shares is $30. If new common shares are issued, it will be necessary to incur flotation costs of $5 per share. The firm's bonds have a par value of $1,000; a coupon rate of 7 percent paid annually; 10 years to maturity; and currently sell for $1,050 each. Flotation costs on similar new bonds would be 4 percent of the par value on an after-tax basis. The firm is considering a project with an investment of $10 million. The firm doesn't have enough cash for the investment and will have to issue common shares to raise the $10 million.

What is the required rate of return on this investment if the firm's tax rate is 40 percent and the project has the same level of risk as the firm?

Question 3

The Triple-A Manufacturing Co. is considering the purchase of a machine. The machine will cost a total of $50,000 and has an expected useful life of 6 years. The company's cost of capital is 12% and the inflation rate in Canada is expected to be 6% annually for the foreseeable future.

The following projections are made:

• The machine will produce 8,000 units annually.
• In the first year, each unit will sell for $5.00.
• Subsequent increases in the selling price are expected to be 5 percent per year.
• Labour costs will be $10,000 in the first year of operations are expected to rise by 10 percent each year.
• Materials will cost $12,000 in the first year and will rise by 6 percent annually.
• Other expenses total $1,500 in the first year and will rise by 2 percent a year.
• Corporate taxes are 40 percent.
• The CCA rate is 30 percent.

Should the company purchase the new machine? Follow the "template" (example on page 4 of the "inflation" handout)- i.e., the "long way"- and then compute the NPV.