Eastern Communications Corporation & After Tax Cost of Debt Kd Problems Materials in the file Materials in the file Materials in the file Materials in the

Eastern Communications Corporation & After Tax Cost of Debt Kd Problems Materials in the file Materials in the file Materials in the file Materials in the file Materials in the file Materials in the file Materials in the file Materials in the file Materials in the file Materials in the file Materials in the file Materials in the file Problem #1 (23 marks)
Eastern Communications Corporation (ECC) is a Canadian Industrial company with several
electronics divisions. The firm would like you to calculate the weighted average cost of capital as
they are considering a new expansion project. You have been provided with the firm’s most recent
financial statements as well as the following additional information:
Eastern Communications Corporation
$millions
Assets
Liabilities & Shareholders’ Equity
Cash & short-term securities
$10
Bonds, coupon =9%, paid semi-annually
(maturity 15 years, $1,000 face value)
$10
Accounts Receivable
8
Preferred Stock (Par value $20 per share)
2
Inventories
7
Common Stock (1,000,000 shares outstanding) 10
Plant & Equipment
25
Retained Earnings
28
Total
$50
Total
$50
The financial manager has gathered the following information for the firm:
Debt: The bonds are currently selling at a quoted price of 102.4. New debt would be issued at
par ($1,000) with flotation costs of 2.5%
Preferred Shares: The existing preferred shares are currently selling for $25 per share. The firm
can sell new $100 par value preferred shares with a 12% annual dividend. The market price is
expected to be $95 per share. Flotation costs for new preferred shares are estimated at 3%.
Common Equity: The firm’s common shares currently sell for $18 per share. The firm does not
have enough cash on hand to finance the equity portion of the projects. ECC has a tax rate of 40%
and a beta of 1.79. You have observed the following from the market: an 8% market risk premium
and a 2% risk free rate. Flotation costs for new common shares are estimated at 5%.
The financial manager of ECC is evaluating equipment purchases with a total capital cost of $480,000
and shipping costs for equipment of $20,000. The present value of the after-tax operating cash
flows will be =$389,044, present value of CCA tax shield will be $107,776, and present value of
terminal (ending) cash flows will be $19,998.
a) Calculate the discount rate the firm should use to evaluate projects with the same level of risk as
the firm. (14 marks)
b) Would this expansion create value for ECC? Perform a NPV analysis. Assume the asset class will
remain open. (9 marks)
1
Problem #2 (10 Marks)
Sunny Days Corporation is establishing a new division to manufacture and sell outdoor furniture made
from recycled plastic. This new division has a much higher risk level than the parent company. The
following information is available on the parent company, its new division, and the market:
• Sunny Days Corporation: β = 0.5, D/E = 0.75, tax rate = 30%, RD = 7%
• Market information: Return on government 3- month T-bill = 5%, Expected return on the TSX =
10%
Sunny Days has identified a pure play company to use in its analysis of the new division.
• Pure play: β = 1, WD = 40%, WE = 60%, tax rate = 40%, RD = 9%
Determine the appropriate discount rate that Sunny Days should use when evaluating projects for its
new division. The new division will have the same tax rate and cost of debt as Sunny Days.
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