After discussions with an investment banker about issuing additional debt, your analystfound that the cost of debt (before tax) depends on the amount of debt in the capitalstructure. Cost of debt estimates for various levels of debt financing (D/E) were obtainedand the firm's analysts have partially prepared information for the company's cost ofcapital at various levels of debt and equity:DIAE/AD/E(W.)rara(1-T)(Wco)reWACC0.0000.00%0.00%0.911.0005.02%5.022%0.502.05%1.220.4112.55%1.003.75%5.068%Where:ra = before tax cost of debt,o ra(1-T) = after tax cost of debt,b = beta,rs = cost of common equity,Wa = Weight of debt,Wce = Weight of common equity,%3DKEMPER uses the firm's WACC for average-risk projects, and it adds 2% for high-riskprojects. For low-risk projects, it uses the WACC less 2%.Management utilizes risk-adjusted hurdle rates for evaluating capital budgeting projects.All potential projects are classified using a five-level classification system:Risk LevelClassHurdle RateLow riskBelow average riskNormal riskAWACC – 2WACC – 1Equal to the WACCWACC + 1ВCAbove average riskHigh riskDEWACC + 2KEMPER considers the proposed project to be a high-risk project.Given all of the information provided in this case:(Show your work, calculations, and explain your answers well)Cost of Capital, Capital Structure, Hurdle Rate:What is the firm's current Weighted Average Cost of Capital (WACC) at its currentcapital structure?• Capital Structure theory addresses finding a firm's optimal capital structure. How do youdetermine the optimal capital structure?• What is the company's optimal capital structure? (First, complete the Cost of Capital &Capital Structure worksheet) B.E. Kemper, LLC (KEMPER) is a custom parts fabricator supporting the classic auto andrecreational marine industries.The company is evaluating a proposal by its Marketing department to develop one-of-a-kind,customize parts for resto-mod professionals and the hobbyist in their desire for that special,unique "new" old car/truck. This approach will require the expertise of design artists andengineers working with the restorer and the need for custom programs, computer-aided design,CNC milling equipment, and both polymer & metal 3D printing equipmentMarket studies indicate that the restoration market is continuing to grow and is broadening toinclude the newer 'classic' vehicles of the '80s and '90s. The industry consists of bothprofessional restoration shops and many talented hobbyists. The anticipated demand isincorporated in the forecasts below.Sales Forecast:The estimate of sales revenues for this project is $1,250,000 in year 1. Sales growth of50% is forecast for year 2, 30% for year 3, then the growth rate settles to 10% each yearfor years 4, 5 and 6. Sales are then stable with a growth rate of 0% (equal to year 6) inyears 7 and 8. Finally, sales are expected to decline by 10% in year 9.Production cost forecasts are:Fixed costs: $455,000 per year (a large portion of this cost is labor for thedesigner and engineer).o Annual variable costs: 46% of sales revenue.The company will have to purchase new equipment, mentioned above, to produce thenew product. The equipment, including shipping and installation, is expected to cost(t=0) $ 5,325,000.• The equipment falls into the IRS 10-year class life using the MACRS depreciationmethod with the ½ year convention. (See MACRS table).• If the company goes ahead with the proposed product, it will affect the company's netoperating working capital. At the outset, t = 0, inventory will increase by $265,000.Accounts receivable will increase by $125,000, and accounts payable will increase by$245,000.The net operating working capital will be liquidated after the project is completed.The program (project) is planned to continue for 9 years. At the end of the project, theequipment will be salvaged (sold). The forecasts predict that the equipment can be soldthen for $225,500.Current Capital StructureKEMPER has the following levels of debt and common equity (market values):o Debt:o Equity:o Total Capital: $11,916,000$ 4,894,300$ 7.021,700The company has a marginal (federal + state) tax rate (T) of 31%, and uses MACRSdepreciation.MACRS (half-year convention incorporated)Depreciation (% of depreciable basis)Class - life10-Year20.00% 14.29% | 10.00%32.00% | 24.49% | 18.00%Year of Operation3-Year5-Year7-Year133.33%44.45%14.81%19.20%17.49%14.40%47.41%11.52%12.49%11.52%11.52%8.93%9.22%5.76%8.92%7.37%78.93%6.55%4.46%6.55%9.6.56%6.55%10113.28%Your analysts compiled current market information:o Market risk premium (rm – rH): 4.25%Risk-free rate (rn):1.14%The company's beta (at its current capital structure) is: 1.34

The current capital structure of the company is D/A = $4894300/$11916000 = 0.411…

After discussions with an investment banker about issuing additional debt, your analyst found that the cost of debt (before tax) depends on the amount of debt in the capital structure. Cost of debt estimates for various levels of debt financing (D/E) were obtained and the firm's analysts have partially prepared information for the company's cost of capital at various levels of debt and equity: E/A (Wee) D/A D/E (W) ra ra(1-T) b re WACC 0.000 0.00% 0.00% 0.91 1.000 5.02% 5.022% 0.50 2.05% 1.22 0.411 2.55% 1.00 3.75% 5.068% Where: ra = before tax cost of debt, o ra(1-T) = after tax cost of debt, b = beta, rs = cost of common equity, o Wa = Weight of debt, o Wce = Weight of common equity, KEMPER uses the firm's WACC for average-risk projects, and it adds 2% for high-risk projects. For low-risk projects, it uses the WACC less 2%. Management utilizes risk-adjusted hurdle rates for evaluating capital budgeting projects. All potential projects are classified using a five-level classification system: Hurdle Rate WACC - 2 Risk Level Class A Low risk Below average risk WACC - 1 Equal to the WACC WACC + 1 C Normal risk Above average risk High risk E WACC + 2 KEMPER considers the proposed project to be a high-risk project. Given all of the information provided in this case: (Show your work, calculations, and explain your answers well) Cost of Capital, Capital Structure, Hurdle Rate: What is the firm's current Weighted Average Cost of Capital (WACC) at its current capital structure? • Capital Structure theory addresses finding a firm's optimal capital structure. How do you determine the optimal capital structure? What is the company's optimal capital structure? (First, complete the Cost of Capital & Capital Structure worksheet)

4th Edition

ISBN:9781305970663

Author:Don R. Hansen, Maryanne M. Mowen

Publisher:Don R. Hansen, Maryanne M. Mowen

Chapter11: Strategic Cost Management

Section: Chapter Questions

Problem 4CE: Kagle design engineers are in the process of developing a new green product, one that will...