You are asked to do a capital budgeting evaluation of a new project. The purchase price of machinery is $810,000. The equipment would depreciate according to the 7-year MACRS class (use the depreciation percentages provided in Exhibit 2 below). It is anticipated that the variable operating costs, excluding depreciation, will be approximately 40 percent of sales. In the project's first year, incremental fixed costs (maintenance, etc.) are projected to be $25,000. In each of the remaining years, this fixed cost component is projected to increase by 2% over the preceding year.

The firm anticipates that it will have to make incremental working capital investments to parallel the expected changes in sales. Analysis has resulted in the estimate that a proper working capital requirement figure would be 8 percent of sales (i.e., the incremental NWC investment (or recovery) at time t will be 8% of the change in sales between time t, and t + 1 such that cumulative investments in NWC made over the life of the project would be fully recovered in the project's final year). The machinery is expected to be sold for a before-tax scrap value of $120,000 at the end of year 6. The sales projections (revenues) anticipated for this investment are shown in Exhibit 1 below.

The weighted average cost of capital (WACC) of the project is the same as the firm's WACC. You also know:

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  • The firm has 15,000,000 shares of common stock outstanding that are trading for $18.20 per share.
  • Risk-free rate is 2.62%, equity Beta is 1.4, market risk premium is 6.5%, and marginal tax rate is 21% .
  • The firm's bonds have 6% coupon rate, a $1,000 face value, pay semi-annual coupons, and mature in 15 years. There are 100,000 of these bonds outstanding that are currently selling in the open market for $960 per bond. 
  • What is the cost of equity?
    • What is the cost of debt before taxes? 
    • What is the free cash flow for Year 0
    • What is the free cash flow for Year 1
    • What is the free cash flow for Year 6
    • What is the NPV of the proposed project

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Exhibit 1. Sales Projections for New Machinery Year Sales Projection 1 Year $300,000 Exhibit 2. 7-year MACRS schedule 1 2 $420,000 2 3 3 $510,000 4 $600,000 5 4 Depreciation 14.29% 24.49 % 17.49 % 12.49 % 8.93% 6 5 $480,000 8.92% 7 6 $360,000 8 8.93% 4.46% Exhibit 1. Sales Projections for New Machinery Year Sales Projection 1 Year $300,000 Exhibit 2. 7-year MACRS schedule 1 2 $420,000 2 3 3 $510,000 4 $600,000 5 4 Depreciation 14.29% 24.49 % 17.49 % 12.49 % 8.93% 6 5 $480,000 8.92% 7 6 $360,000 8 8.93% 4.46%

Answer rating: 100% (QA)

SOLUTION To evaluate the new project we need to perform the following calculations 1 Cost of equity ... View the full answer