Calculate the discount rate the firm should use

Reference no: EM132206311

Question - GPS Inc. currently has $50,000,000 in bonds outstanding with a coupon rate of 6% paid semiannually and a maturity of 10 years. The bonds are currently selling at a quoted price of 90. The company also has 50,000 shares of 10% preferred stock outstanding ($100 par), currently selling for $95 per share. In addition, the company has 1,000,000 common shares outstanding, selling for $60 per share. The firm has a tax rate of 40%, a beta of 1.75, an ROE of 20%, and a dividend payout ratio of 40%. The firm just paid a dividend of $2 per common share. Flotation cost to issue new debt is 2%, new preferred share is 4%, and new common share is 6%. The firm has $5,000,000 in internally generated funds available.

a) Calculate the discount rate the firm should use to evaluate projects with the same level of risk as the firm.

b) Over the last two years, GPS Inc. incurred a cost of $100,000 for conducting a feasibility study on a new project. The project requires purchasing a new machine that will cost $2,200,000 plus an additional $300,000 in installation costs. Management estimates that the firm will obtain annual operating revenues before taxes of $1,000,000 and incur annual operating expenses before taxes of $400,000 over the economic life of the project. The specifications of this machine indicate an economic life of ten years and management estimates that at the end of the economic life, the machine will have a salvage value of $200,000. This machine is in asset class 8 which has a CCA rate of 20%. The asset class is expected to remain open at the end of the project. Finally, management expects to make an initial investment in working capital of $400,000, which will be recovered at the end of the economic life of the project.

Calculate the following: the weighted average flotation cost, initial investment (amount needed), amount raised, flotation costs (in $), annual tax shield associated with flotation costs, present value of annual tax shield associated with flotation costs, present value of the after tax operating cash flows, present value of salvage value, present value of net working capital, and present value of CCA tax shield. Based on NPV analysis, should the project be undertaken? Assume this project will have the same level of risk as the firm. Show your work.

c) How would your answers to question (b) change if the firm had no internally generated funds? Explain.

Reference no: EM132206311

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