Sap Paper Mill is considering $165 million upgrade of its machinery. Once the plant is upgraded, the machinery will last for 30 years. The upgrade is expected to generate the following net cash flows: $25 million annually in the first decade after the investment; $20 million annually in the second decade after the investment, and $15 million annually in the last decade of the investment. At the end of the 30th year, the firm also anticipates that it can sell the equipment (as parts) for a total salvage value of $1 million.   

Before committing to this investment, the company asked you, their Business Consultant, to evaluate this capital budgeting project given the various sources of funding available to them. To assist you, the firm gathered the following data:

The firm's corporate tax rate is currently 40 percent. The tax rate is not expected to change throughout the life of the project.

The company can issue 30-year bonds with a 12% coupon, paid semi-annually, and par value of $1,000 for $1,153.72. The bond’s flotation costs would be 1% of the par value.

The current price of the firm's 10 percent, $100 par value, preferred stock is $113.10. If the firm issues new preferred stock, the firm will have to maintain the preferred stock dividend rate constant, and pay $2 in flotation costs per each new preferred share issued.

The firm’s common stock is currently selling for $50 per share. Its last dividend (D0) was $4.19 per share. Common stock dividends are expected to grow at a constant rate of 5 percent per year in the foreseeable future.

If the firm issues new common stock, the net proceeds per share are estimated to be 15 percent less than the current price of common share.

Sap’s beta is 1.2. The yield on a 30-year US Treasury Bond is 7 percent per year, and the S&P’s rate of return is currently 13 percent per year.

The firm’s target capital structure is 30 percent long-term debt, 10 percent preferred stock, and 60 percent common stock equity.

Given this information, the firm asked you to answer the following questions and provide supporting evidence (formulas, calculations, etc) behind your evaluations.

1. What cost(s) of capital should the firm use when evaluating whether or not to invest in this project? Why should they use this/these cost(s) of capital? 
2. They should use the weighted average cost of capital because
3. What is the firm’s after-tax cost of debt financing?
4. What is the firm’s cost of preferred stock financing?
5. According to CAPM, what is the firm’s cost of financing using the retained earning?
6. According to the Gordon Growth Model, what is the firm’s cost of financing using the retained earning? 
7. What is the firm’s cost of equity, if the firm issues new common stock?
8. What is the firm’s weighted average cost of capital if the firm uses debt, preferred stock and retained earnings? What cost of retained earnings did you use here and why?
9. What is the firm’s weighted average cost of capital if the firm uses debt, preferred stock and equity from the new common stock issue? 
10. Should the firm finance the plant’s machinery upgrade? If so, how should the firm finance it? Provide evidence to support your recommendation 

Answer rating: 100% (QA)

1They should use the weighted average cost of capital because Given that the firms target capital structure is 30 longterm debt 10 preferred stock and ... View the full answer