SECTION C (35 marks) Answer ONE question Question 13 (answer all parts) GlaxoSmithKline plc is a pharmaceutical company. It is considering the replacement of one of its existing machines with a new model. The existing machine can be sold now for $8,000. The new machine costs $50,000 and will generate free cash flows of E11,416.55 p.a. over the next 6 years. The corporate tax rate is 35%. The new machine has average risk. GlaxoSmithKline's debt-equity ratio is 0.5 and it plans to maintain a constant debt-equity ratio. GlaxoSmithKline's cost of debt is 5.85% and its cost of equity is 13.10%. a) Compute GlaxoSmithKline's weighted average cost of capital. (5 marks) b) What is the NPV of the new machine and should GlaxoSmithKline replace the old machine with the new one? (10 marks) c) The average debt-to-value ratio in the pharmaceutical industry is 20%. What would GlaxoSmithKline's cost of equity be if it took on the average amount of debt of its industry at a cost of debt of 5%? Do this calculation assuming the company does not pay taxes. (10 marks) d) Given the capital structure change in question c), Modigliani and Miller would argue that according to their theory, GlaxoSmithKline's WACC should decline because its cost of equity capital has declined. Discuss. (10 marks)Explanation: a) Weighted Average Cost of Capital = Weight of Equity x Cost of Equity + Weight of Debt x After tax cost of debt Weighted Average Cost of Capital = 1/(1+0.5)*13.10% + 0.50/(1+0.5)*5.85%*(1-35%) Weighted Average Cost of Capital = 10% b) NPV = -Initial Investment + PV of Future Cash Flow NPV = -(50000-8000) + 11416.55*(1-1/(1+10%)^6)/10% NPV = 7722.05 c) Existing Levered Cost of Equity = 13.10% Unlevered Cost of Equity = (Levered Cost of Equity+ Cost of Debt*D/E*(1-tax rate))/(1+ D/E*(1-tax rate)) Unlevered Cost of Equity = (13.10% + 5.85%*0.5*(1-35%))/(1+0.5*(1-35%)) Unlevered Cost of Equity = 11.32% Industry Debt to Value ratio = 20% Industry D/E = 20%/(1-20%) Industry D/E = 1/4 = 0.25 Assume the company does not pay taxes Companys Cost of Equity = Unlevered Cost of Equity + (Unlevered Cost of Equity-Cost of Debt) x D/E Companys Cost of Equity = 11.32%+ (11.32%-5%)*0.25 Companys Cost of Equity = 12.90%