FIN-401 Midterm – Fall 2007

Part II

Student Name: _________________________

31. The Canadian Eagle Company has the following capital structure:

Par/Book Value # outstanding Market Price

Bonds $1000 30,000 $912
Common Shares $50 1,500,000 $75
Preferred Shares $100 100,000 $102

Additional information:
Suppose the company just paid a dividend of $2.00 and the dividend is expected to grow
at 9% per year forever.
The firm’s tax rate is 40%.
The bond has a 5% coupon rate, pays interest annually and has 20 years to maturity.

Questions:

What is the capital structure weight of debt? (1 mark)

What is the capital structure weight of Common Stock? (1 mark)

What is the capital structure weight of Preferred Stock? (1 mark)

What is the after tax cost of debt? (1 mark)

What is the cost of Common Stock? (1 mark)

What is the cost of Preferred Stock? (1 mark)

What is the WACC? (2 mark)

Answers:

Debt Preferred Common Total

Market Value 27,360,000 10,200,000 112,500,000 150,060,000

Capital structure weight of debt 18.23%

Capital structure weight of Common Stock 74.97%

Capital structure weight of Preferred Stock 6.80%

After tax cost of debt 3.45%

Cost of Common Stock 11.91%

Cost of Preferred Stock 4.90%

WACC 9.89%

32) BIG OIL Corporation purchased a machine three years ago for $200,000. The
machine is expected to last for another 5 years. A new machine with a cost $150,000 is in
the market; the new machine is expected to have a useful life of 5 years. The new
machine is able to cut the production cost by $27,000 per year. The salvage value of the
new machine after 5 years is $30,000. The existing machine can be sold for $40,000
today, and will be worthless after 5 years. The CCA rate of the machine is 30%, the tax
rate of BIG OIL is 40% and the required rate of return is 12%. Evaluate the proposal to
replace the existing machine with the new one using NPV analysis? (7 marks)

Answer:

Cost of New Machine -$150,000.00

Salvage value of Old Machine today $40,000.00
Net investment -$110,000.00
P.V. A.T. savings $58,397.37
P.V. of CCA (net new investment) $29,744.90
P.V. Salvage (new machine) $17,022.81
P.V. of CCA on Salvage(new machine) -$4,863.66
P.V. Salvage lost (old machine) $0.00
P.V. of CCA on Salvage(old machine) $0.00
NPV -$9,698.58