After discussions with an investment banker about issuing ad

July 26, 2017

After discussions with an investment banker about issuing additional debt, your analyst found that t… Show more 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. Jamnic Digital Automotive’ cost of debt estimates for various levels of debt financing (D/E) were obtained. Fanning Analytics, Inc. D/E Debt/ Capital (Wd) rd Equity Beta Equity/ Capital (We) rs WACC 0.00 0.0 n.a. 1.0 0.333 0.25 5.12% 1.43 0.40 7.25% 0.60 8.00% * Debt/Capital = Debt/(Debt + Equity), Equity/Capital = Equity/(Debt + Equity). 6. a. Complete the table above (show your calculations and formulas in Excel). b. (Choose the correct response and fill in the blank. ) If our goal is to maximize the value of the firm, the “Optimal Capital Structure” is the choice of debt and equity (D/E) that ________ [maximizes/minimizes] the firm’s cost of capital (WACC). c. Based on the information given in the table you completed, should Jamnic Digital Automotive change its capital structure from its current level (D/E = .333)? That is, what is the firm’s optimal capital structure? BACKGROUND INFORMATION Jamnic Digital Automotive manufactures a variety of electronic products. The company is considering introducing its most exciting product; a new digital instrument panel for customized classic cars. This panel allows the car owner to customize the complete set of instruments for the vehicle. Output display may be analog or digital, with many styles of display using apps that may be purchased, downloaded, and installed with a micro SD card. Your analysts have provided you with the following forecast information for the “Fully Customizable Instrument Panel” (FCIP): · The project has an anticipated economic life of 5 years. · The company will have to purchase a new machine to produce the new product. The machine has an up-front cost (t = 0) of $2,107,000. · The equipment will be depreciated using the MACRS method using the ½ year convention with a 5 year class life: t = 1 20.00% t = 2 32.00 t = 3 19.20 t = 4 11.52 t = 5 11.52 t = 6 5.76 · At the end of the project, the expected value (salvage value) of the equipment is $925,000. · If the company goes ahead with the proposed product, it will have an effect on the company’s net operating working capital. At the outset, t = 0, inventory will increase by $136,000 , accounts payable will increase by $52,000, and accounts receivable will increase by $41,500. At t = 5, the net operating working capital will be recovered after the project is completed. · The new product is expected to generate incremental sales revenue as follows: Year 1: $1,200,000 Year 2: 2,500,000 Year 3: 3.250,000 Year 4: 3,100,000 Year 5: 1.575,000 · The operating costs, excluding depreciation, are expected to be 59% of the annual sales. · The new product is expected to reduce the after-tax cash flows of the company’s other existing products by $175,000 a year (t = 1, 2, 3, 4, and 5). · The company’s tax rate is 40 percent. · Jamnic considers this to be a higher risk project. The before tax cost of debt (rd) for Jamnic s 5.12%, and the common stock beta is 1.43. The current capital structure (market value) is as follows: Jamnic Digital Automotive. Debt $2,450,000 Equity 7,350,000 $9,800,000 Jamnic Digital Automotive uses the firm’s WACC for average risk projects, it adds 2% for high risk projects. For low risk projects it uses the WACC less 2%. Your analysts also compiled current market information: Market risk premium (RPm): 4% Risk-free rate (rRF): 2.25% • Show less

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