Vaximax Inc. has asked you to estimate its cost of capital. You have been provided with its most
recent financial statements:
Extracts – Balance Sheet as @ 30 September 2021
(in thousands of dollars)
Common stock $168,000
Long Term Debt $475,000
Preferred Shares $ 125,000
Additional information:
• The company currently has 6.5% coupon, semi-annual payment bonds which were issued at
103.8 percent of par. The bonds mature in September 2031.
• Flotation costs on new debt are 7 percent of the par value.
• The company has 4 percent preferred shares which have a book value of $75 but currently sell
for $60 per share. Preference dividends are paid semi-annually.
• The company’s common shares which have a book value of $15 per share, are currently selling
at $20 per share.
• The company’s two closest competitors have betas of 1.6 and 1.8 respectively. The current
Treasury bill rate is 3.5%. The market rate of return on companies with similar risk
characteristics as Vaximax Inc. is 7%.
• The firm’s tax rate is 25%.
Required:
a) Calculate Vaximax’s after-tax cost of debt. (6 marks)
b) Calculate Vaximax’s cost of equity. (4 marks)
c) Calculate Vaximax’s cost of preferred shares. (4 marks)
d) Calculate Vaximax ’s Weighted Average Cost of Capital (8 marks)
e) Based on its capital structure, would you categorize this firm as being highly financially leveraged?
Why? (2 marks)
f) What are the pros and cons of financial leverage? (4 marks)
g) Explain why using a firm’s WACC is not always appropriate for the evaluation of a new project
Kayeso Corp plans to buy a new machine to replace an old machine. The new machine is expected to
cost $600,000. The firm will also incur $38,000 in installation costs. The firm spent $50,000 researching
the suitability of the new machine. The new machine has an expected life of five years. Additional
investment in working capital of $65,000 will be required at the start of the first year of operation. An
additional $20,000 in working capital is expected at the end of year three. At the end of five years the
machine will be sold for scrap, with the scrap value expected to be 6% of the initial purchase cost of the
machine. The old machine was bought 5 years ago for $380,000 and now has a book value of $18,000.
The market value of the old machine is $5,000.
Production and sales from the new machine are expected to be 50,000 units per year. Each unit will have
a contribution margin of $6 in the first year, and selling price inflation will be 7% while variable cost
inflation will be 2% thereafter. Prior to the purchase of the machine, total fixed costs per year were
$170,000 but with new machine, total fixed costs will rise to $320,000 per year. During year 4, the
company is expected to have an increase in maintenance expenditure of $25,000 due to the aging assets.
Innova Inc. has an after-tax cost of capital of 9% which it uses as a discount rate in investment appraisal.
The company pays corporate profit tax at an annual rate of 30%.
Required:
a) Calculate the net present value of investing in the new machine and advise whether the investment
is financially acceptable. (12 marks)
b) Calculate the internal rate of return of investing in the new machine and advise whether the
investment is financially acceptable.
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