nda and Sitwala Company is considering manufacturing special drill bits and other equipment for mining rigs. The proposed project is currently regarded as complementary to its other lines of business, and the company has certain expertise by virtue of its having a large mechanical engineering staff. Because of the large outlays required to get into the business, management is concerned that Kunda and Sitwala earn a proper return. Since the new venture is believed to be sufficiently different from the company’s existing operations, management feels that a required rate of return other than the company’s present one should be employed. The financial manager’s staff has identified several companies (with capital structures similar to that of Kunda and Sitwala) engaged solely in the manufacture and sale of mining drilling equipment whose common stocks are publicly traded. Over the last five years, the median average beta of these companies has been 1.28. The staff believes that 18 percent is a reasonable estimate of the average return on stocks “in general” for the foreseeable future and the treasury bills rate will be around 12 percent. In financing projects, Kunda and Sitwala uses 40 percent debt and 60 percent equity. The after-tax cost of debt is 18 percent and corporate tax is 35 percent. Required

CONCEPTS IN FED.TAX.,2020-W/ACCESS

20th Edition

ISBN:9780357110362

Author:Murphy

Publisher:Murphy

Chapter15: Choice Of Business Entity—other Considerations

Section: Chapter Questions

Problem 89TA

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Question

Kunda and Sitwala Company is considering manufacturing special drill bits and other equipment for mining rigs. The proposed project is currently regarded as complementary to its other lines of business, and the company has certain expertise by virtue of its having

a large mechanical engineering staff. Because of the large outlays required to get into the business, management is concerned that Kunda and Sitwala earn a proper return. Since the new venture is believed to be sufficiently different from the company’s existing operations, management feels that a required rate of return other than the company’s present one should be employed.

The financial manager’s staff has identified several companies (with capital structures similar to that of Kunda and Sitwala) engaged solely in the manufacture and sale of mining drilling equipment whose common stocks are publicly traded. Over the last five years, the median average beta of these companies has been 1.28. The staff believes that 18 percent is a reasonable estimate of the average return on stocks “in general” for the foreseeable future and the treasury bills rate will be around 12 percent. In financing projects, Kunda and Sitwala uses 40 percent debt and 60 percent equity. The after-tax cost of debt is 18 percent and corporate tax is 35 percent.

Required

a) Compute the required rate of return for the project

b) Compute the weighted average cost of capital for the project

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