Mike is the chief financial officer (CFO) of a company, an electronic calculator producer. As a financial

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Question:

Mike is the chief financial officer (CFO) of a company, an electronic calculator producer. As a financial management graduate, you are expected to assist the CFO with financial analysis. During the past few years, the company has been too constrained by the high cost of capital to make investments. Mike is interested in measuring the company's overall cost of capital, and provided you with the following data, which he believes may be relevant to your task: Ordinary shares (60%): Ordinary shares are currently trading at R12 per share. An ordinary dividend of R0,50 per share has recently been paid and dividends are expected to grow at 10% per annum for the foreseeable future. Preference shares (20%): Preference shares are currently trading at R1.10 per share. The company is expected to issue R0.12 dividends per share in the next financial year, and flotation costs would amount to R0.10 per share. Long-term debt (20%): R1 000,00 par value, 10% coupon and five-year bonds that could be sold for R1 200,00, will be issued with a flotation cost of R25,00 per bond. Company tax rate is currently 28%

a) Using the information provided above, calculate the weighted average cost of capital (WACC) for the company.

Additional information:

The company is considering the replacement of outdated equipment, which will allow the company to manufacture a new line of electronic calculators. Mike confirmed that the company is considering two mutually exclusive projects for the replacement. Information regarding expected cash flows from the two projects is as follow: PROJECT A The cost of the new equipment is R8,5 million and the company qualifies for a depreciation deduction of 40% of cost in the first year and 20% in each of the subsequent three years. The equipment is also expected to reduce the cost of producing an existing product line by R180 000 per annum before tax for another four years, when the life of this product line is expected to end. The expected residual value of the equipment is R2,1 million in four years' time. The new line of products will result in a selling price of R85 per unit and variable cost of R38 per unit. The product line is expected to result in a constant demand of 70 000 units per annum for four years. The current tax value of the present equipment is R300 000 and its current market value is R410 000. The equipment is expected to have a residual value of zero in four years' time.

The investment in net working capital will amount to R475 000.

PROJECT B

Year Project A Cf (R)

0 2 500 000

1 800 000

2 1 000 000

3 1 000 000

4 2 000 000

5 2 000 000

6 930 000

b) Considering all the information supplied thus far and the company's overall risk, which project should the company choose? Give reasons for your choice.