Managerial Finance Case Study: Cost of Capital, Investment Evaluation, and Replacement Decision

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Managerial Finance
Executive Summary
Managerial Finance offers international forum for publishing high quality with topical
research in field of finance like financial management, corporate finance, insurance, banking,
risk management etc (PEREZ, 2018). The case study deals with an Australian firm into the
business of defense products. In the first part of the Case Study we have been asked to calculate
the cost of capital for the firm. The question specifies that the firm is having debts that include
unsecured notes and debentures and equity consisting of preferred stock and ordinary shares.
The second part wants us to evaluate between two offers that the firm has received. In
offer 1, the firm can invest 1.5 million in a new machinery and refurbishing of plant. It must
invest further in Working Capital that would be 10% of the revenue generated. The cash inflows
of the company would be from revenue generated through sale of duffels, tax advantage on
depreciation, release of working capital and salvage value. The second offer the company can
earn 1.3 million by selling the land although it needs to get the land developed at first.
In the third part the firm has to make a replacement decision between a existing and a
new machine. It must decide whether to install a new machine or to continue with the old one.

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Analysis
Part 1
Part 1 of the question requires calculation of cost of capital. We have calculated that in
the following way:
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Managerial Finance
For the 1000 unsecured notes which are paying coupon semiannually and are due for
maturity in years. Now since they are paying coupon semiannually the rime would be doubled
for them i.e. 11*2 years = 22 years. The market value of the bond is $980. To determine the Kd
i.e. cost of debt we should take out the YTM of the bond. For that we have assumed that the
YTM of the bond is 5% then the market price comes up to $868, then we reduce the bond’s
YTM to 4% and the bond value comes up to $980 i.e. market value of the bond.
For the debentures we should again calculate the Kd. We would calculate the YTM of the
debentures. If we take Kd @10% then the bond value comes up to $1054, hence we would lower
the Kd and take it @9%, the bond value now comes up to $1111 which is approximately equal to
the market price of the bond.
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