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WACC/Capital budgeting

Question 1

Patrick Brennan runs his own business, Brennan Consulting, an information technology (IT) consulting firm. The company has grown dramatically. He has 50 employees and his company's annual revenue equals $10 million. His company went public five years ago and two million shares in Brennan Consulting (BC) trade on the TSX Venture Exchange. You and Patrick have developed a close working relationship as a result of the good advice you have provided him throughout the years, and you are now his chief financial officer (CFO).

BC is now considering a substantial expansion opportunity. Your first step in evaluating this opportunity is to estimate BC's weighted average cost of capital (WACC). You have accumulated the following information for BC:

? Book value of long-term debt is $4 million.
? Book value of common equity is $6 million.
? There are no preferred shares outstanding.
? BC has no short-term debt outstanding.
? All of BC's long-term debt consists of a five-year term loan with its bank, which calls for monthly payments of $78,452.09. You have determined that the going market rate on this loan is 6% compounded monthly.
? The firm's common shares currently trade at a market-to-book-value ratio of 2.0:1.
You have also determined the following through discussions with investment dealers:
? BC could raise the new debt required for the expansion by issuing 10-year bonds that pay semi-annual coupons based on a 5% coupon rate.
? The firm would "net" $98 per $100 per bond on an after-tax basis after issuing and underwriting costs.
? BC's common shares paid an annual dividend of $0.30 per share and this amount is expected to increase at an annual rate of 4% indefinitely.
? If necessary, BC could issue new shares at the current market price of $6.00, with 10% pre-tax issuing and underwriting costs.
? The firm's tax rate is 30%.

a. Determine the appropriate weights to use in determining BC's WACC.
b. Calculate BC's cost of debt, cost of internal equity, and cost of issuing new common equity.
c. Based on your calculations in parts (a) and (b), estimate the firm's WACC, assuming all of the required equity can be generated internally.
d. You have estimated that the firm will generate $1 million in internally-generated funds that are available to fund new investments. How much can the firm raise without issuing new equity, based on your previous calculations? What is the firm's marginal cost of capital (MCC) for financing required beyond this figure?

Question 2

BC is considering opening a new office in Calgary to capitalize on the growth in activity in that area, and because it already has several large clients based there. The firm has already invested $20,000 in investigating this expansion opportunity. The research to date suggests that the expansion will produce additional annual operating revenue of $400,000, and additional annual operating expenses of $275,000, all before taxes, for five years. BC will lease the office space for a five-year period, and the leasing expenses are included in the annual operating costs.

The expansion will require an investment in computer equipment at an initial outlay of $300,000, plus an additional $50,000 in installation and employee training costs. The computer equipment will have a five-year estimated useful economic life, at which time the estimated salvage value will be $50,000. It is in asset class 45 (CCA rate 45% - declining balance method), and you can assume the asset class will be left open when the project ends. You can also assume that the firm will maintain a substantial UCC balance for this asset class so that CCA recapture will not occur.

Further, the firm requires $100,000 in additional net working capital requirements to start the project and estimates that all of this amount will be released at the end of the five years.

Assume the appropriate discount rate for this expansion is 9% and that BC's tax rate remains at 30%.

a. Estimate the initial after-tax cash outlay.
b. Estimate the net present value associated with this expansion.
c. Estimate the profitability index associated with this expansion.
d. Should BC go ahead with this project? Briefly explain.
e. Given that BC presently has two million common shares outstanding that are trading at $6.00 per share, what will be the new price per share if the firm accepts this project, assuming the markets are efficient?


Solution Summary

The solution explains two questions relating to WACC calculation and project accept/reject decision