Superior Machine Tool, Inc. (SMT) has a target debt-to-equity ratio of 1 to 3, or 0.33. (In other words, the company believes that 25 percent of its permanent capital structure should be in the form of long-term debt and 75 percent should be in the form of equity.) After consulting with the company’s investment bankers, SMT’s chief financial officer believes that if the company were to issue ten-year bonds today, a coupon rate of 5.4 percent would be sufficient to successfully sell the bonds at par value to new investors. In addition, based on the behavior of the company’s stock price over the past several years, SMT’s CFO believes that the company’s cost of equity is about 10 percent. He also estimates that the company’s combined federal and state income tax rate will be about 36 percent for the indefinite future. The company has no preferred stock outstanding and no plans to issue any.
While SMT’s current cash position is more than sufficient to meet the company’s operating needs for the next year or two, today’s capital markets are volatile, and the company’s board of directors has placed a firm upper limit of $30 million for the next two years on the company’s capital expenditures (CAPEX.)
What is the company’s estimated weighted-average cost of capital?
SMT is reviewing two mutually exclusive expansion projects, Project X and Project Y. Both projects would increase the company’s production capacity by the same amount. Project X is essentially an expansion of the company’s current process. Project Y, on the other hand, would result in a more automated process that would reduce labor costs. The estimated annual incremental after-tax net cash flows for each project for the next nine years are summarized below. Should the company proceed with either of the proposed projects? If so, which one? Why? What additional information would you like to have that might help you with your recommendation? How would this information help?
Year Project X Project Y
0 ($ 10,180,000) ($ 12,820,000)
1 ($ 7,160,000) ($ 10,150,000)
2 $ 3,750,000 ($ 1,930,000)
3 $ 5,890,000 $ 5,200,000
4 $ 6,040,000 $ 8,030,000
5 $ 4,660,000 $ 7,570,000
6 $ 2,550,000 $ 6,620,000
7 $ 1,710,000 $ 6,400,000
8 $ 1,320,000 $ 5,010,000
9 $ 1,010,000 $ 3,920,000