CAPITAL BUDGETING (25 marks)

SeaGate Manufacturing is considering the replacement of an existing machine. The new machine costs R1,2 million and requires installation costs of R150 000. The existing machine can be sold today for R185 000 before taxes. It is 2 years old, cost R800 000 new, and has a remaining useful life of 5 years. It is being depreciated under the straight line method over an economic life of 5 years. If held until the end of 5 years, the machine’s market value would be R0. Over its 5-year life, the new machine should reduce operating costs by R350 000 per year. The new machine will be depreciated under the straight line method over an economic life of 5 years. After 5 years the new machine can be sold for an estimated R200 000 net of removal and cleanup costs. An increased investment in net working capital of R25 000 will be needed to support operations if the new machine is acquired. Assume that the firm has adequate operating income against which to deduct any losses experienced on the sale of the existing machine. The firm has a 10 percent cost of capital and is subject to a 40 percent tax rate.

REQUIRED

(a) Develop the relevant cash flows to analyze the proposed replacement. (15)

(b) Determine the payback, net present value (NPV), the internal rate of return (IRR)

and the profitability index (PI) of the proposal. (8)

(c) Make a recommendation and justify your answer. (2)

WEIGHTED AVERAGE COST OF CAPITAL (WACC) (18 marks)

Xylink Corporation’s current sales are R2 000 000 per year, consisting of fixed costs of R500 000 and variable costs of 35% of sales. The company aims at increasing its sales and intends expanding its production capacity by investing R900 000 in a new plant and machinery.

It is company policy to finance 60% of its total financing needs with equity and 40% with debt. At present 50 000 shares have been issued and trade at R50 each, while the company pays R200 000 interest per year on debentures with a yield of 12%. The company’s investment banker also

provided the following information:

- the average return on equity is 8%.

- flotation costs will be 10%.

- the dividend growth rate is expected to be 6%.

- the dividend cover is maintained at 4 times.

- FUN4U’s marginal tax rate is 40%.

REQUIRED

(a) Calculate Xylink’s current retained earnings. (6)

(b) Identify the forms and amounts of new financing required for the proposed investment. (4)

(c) Calculate the weighted average cost of capital (WACC) that should be used in the evaluation of the new investment. (6)

(d) Indicate how many new ordinary shares should be issued. (2)

NOTE: Expecting the solution as soon as possible..

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