Existing Machine New Machine
Book Value = (350000-((350000/5) *4) =70 000 Installed Cost = R750 000
Loss = SP – BV = (R70 000 – R70 000) = 0
Tax Benefit = (0 X 0.28) = 0
Net Working Capital = 7000
Initial Investment
Installed Cost of proposed machine
Cost of proposed machine (R750 000)
+ Installation Costs (R20 000)
Total installed cost – New Machine
(Depreciable Value) (R770 000)
-After Tax Proceeds (Old)
Proceeds from sale of present machine R70 000
-Tax on sale of present machine 0
Total after tax proceeds – Old Machine R70 000
Change in net working-capital R7 000
Initial Investment R693 000
The new project has a negative NPV, hence it is not advisable
QUESTION 2 (15 MARKS)
2.1
Cost of Retained Earnings:
𝐷1 1.26(1.06)
𝑃0 = ⇒ 40 =
𝑟−𝑔 𝑟 − 0.06
40𝑟 − 2.4 = 1.3356
40𝑟 = 3.7356
𝑟 = 0.09339
∴ 𝒓 = 𝟗. 𝟑𝟒%
(It is not necessary to adjust the cost of retained earnings for flotation costs because by
retaining earnings, the firm “raises” equity capital without incurring these costs.
Cost of New Ordinary Shares:
𝐷1
𝑃0 − 𝐹𝑐 =
𝑟−𝑔
Making r the subject of the formula gives:
𝐷1 1.26(1.06)
𝑟= +𝑔= + 0.06 = 𝟏𝟎. 𝟒𝟓%
𝑃0 − 𝐹𝑐 40 − 10
Cost of Preference shares:
𝐷1
𝑃0 =
𝑟−𝑔
Since the preference dividend does not grow, 𝑔 = 0
Range of Total New Financing Source of Capital Weight Cost Weighted Cost
0 – 8 400 000 Debt 0.4 3.84 1.536
Preference Shares 0.1 9.09 0.909
Ordinary Shares 0.5 9.34 4.670
Weighted Average Cost of Capital 7.115%
2.4)
WACC above the BEP for Equity
Range of Total New Financing Source of Capital Weight Cost Weighted Cost
More than 8 400 000 Debt 0.4 3.84 1.536
Preference Shares 0.1 9.09 0.909
Ordinary Shares 0.5 10.45 5.225
Weighted Average Cost of Capital 7.67%
(6)
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