Reference no: EM13213816

What items can you depreciate? Are additions to working capital depreciable?

Bender Guitar Corporation, a manufacturer of custom electric guitars, is contemplating a $1,000,000 investment in a new production facility. The economic life of the facility is estimated to be five years, after which the facility will be obsolete and have no salvage value.

To make the new facility operational, building improvements costing $400,000 will be required. In addition, a $50,000 increase in working capital will be needed.

Bender's accounting and marketing departments have provided the following information: the firm will use the straight-line method of depreciation; the Company is in the 30% tax bracket; the weighted average cost of capital is 8%.

Here are Earnings before Interest and Taxes (EBIT) estimates for the new facility:

Year 1.........$80,000

Year 2.......$100,000

Year 3.......$120,000

Year 4........$140,000

Year 5.......$165,000

Your assignment is to answer the following questions:

1. Diagram the cash flows for the project using a time line. For each of Years 1 through 5, include the following data on your diagram (in this order) : EBIT, tax, depreciation, Operating Cash Flow (OCF), and discounted OCF.

2. Indicate the initial investment cost, the present value, the Net Present Value (NPV), and the payback (measured in years based on non-discounted OCF numbers).

3. Evaluate the project's efficacy. Is this facility worthwhile, based upon your calculations ? Why or why not ? What does the NPV decision rule indicate for this project ? If you were Bender's financial manager, what other factors would you consider before deciding whether or not to recommend construction of the production facility ?

Touring Enterprises, Inc., has a capital structure consisting of $18 million in long-term debt and $7 million in common equity. There is no preferred stock outstanding. The interest rate paid on the long-term debt is 10%. The firm is in the 35% tax bracket. On the common equity (stock), the Company pays an annual dividend of $1.20 and expects to increase the dividend by 5% per year. The market price of the stock is $50. Based on this information, answer the following questions:

1. Calculate Touring Enterprises' weighted average cost of capital (WACC). Work as follows: first, compute the after-tax cost of debt, then compute the cost of equity. Cite both formulas, and show all your work. Then, determine the weightings of debt and equity in the capital structure.

Lastly, using your answers to the above questions, calculate the WACC.

2. If Touring Enterprises were to increase the percentage of debt in its capital structure, what would happen to the WACC ? No calculation is necessary- simply provide a short, non-numeric response.

3. Identify and explain the benefits and risks of debt financing. A two-paragraph answer will suffice.