Burberry Group PLC is a British fashion clothing company. It is considering the replacement of one of its existing machines with a new model. The existing machine can be sold now for £10,000. The new machine costs £60,000 and will generate free cash flows of £12,560 p.a. over the next 5 years. The corporate tax rate is 30%. The new machine has average risk. Burberry's debt-equity ratio is 0.4 and it plans to maintain a constant debt-equity ratio. Burberry's cost of debt is 6.30% and its cost of equity is 14.25%. a) Compute Burberry's weighted average cost of capital. b) What is the NPV of the new machine and should Burberry replace the old machine with the new one? c) The average debt-to-value ratio in the fashion clothing industry is 20%. What would Burberry's cost of equity be if it took on the average amount of debt of its industry at a cost of debt of 5%? Do this calculation assuming the company does not pay taxes. d) Given the capital structure change in question c), Modigliani and Miller would argue that according to their theory, Burberry's WACC should decline because its cost of equity capital has declined. Discuss. e) How could the capital structure change in question c) be explained based on what we know from the trade-off theory of capital structure? Assume the debt-to-value ratio of 20% is the new optimal capital structure for Burberry.
Burberry Group PLC is a British fashion clothing company. It is considering the replacement of one of its existing machines with a new model. The existing machine can be sold now for £10,000. The new machine costs £60,000 and will generate free cash flows of £12,560 p.a. over the next 5 years. The corporate tax rate is 30%. The new machine has average risk. Burberry's debt-equity ratio is 0.4 and it plans to maintain a constant debt-equity ratio. Burberry's cost of debt is 6.30% and its cost of equity is 14.25%. a) Compute Burberry's weighted average cost of capital. b) What is the NPV of the new machine and should Burberry replace the old machine with the new one? c) The average debt-to-value ratio in the fashion clothing industry is 20%. What would Burberry's cost of equity be if it took on the average amount of debt of its industry at a cost of debt of 5%? Do this calculation assuming the company does not pay taxes. d) Given the capital structure change in question c), Modigliani and Miller would argue that according to their theory, Burberry's WACC should decline because its cost of equity capital has declined. Discuss. e) How could the capital structure change in question c) be explained based on what we know from the trade-off theory of capital structure? Assume the debt-to-value ratio of 20% is the new optimal capital structure for Burberry.
Chapter14: Capital Structure Management In Practice
Section: Chapter Questions
Problem 21P
Related questions
Question
I'm really stuck on how to do this how would you answer this ?
Transcribed Image Text:Burberry Group PLC is a British fashion clothing company. It is considering the
replacement of one of its existing machines with a new model. The existing machine
can be sold now for £10,000. The new machine costs £60,000 and will generate free
cash flows of £12,560 p.a. over the next 5 years. The corporate tax rate is 30%. The
new machine has average risk. Burberry's debt-equity ratio is 0.4 and it plans to
maintain a constant debt-equity ratio. Burberry's cost of debt is 6.30% and its cost of
equity is 14.25%.
a) Compute Burberry's weighted average cost of capital.
b) What is the NPV of the new machine and should Burberry replace the old machine
with the new one?
c) The average debt-to-value ratio in the fashion clothing industry is 20%. What would
Burberry's cost of equity be if it took on the average amount of debt of its industry
at a cost of debt of 5%? Do this calculation assuming the company does not pay
taxes.
d) Given the capital structure change in question c), Modigliani and Miller would argue
that according to their theory, Burberry's WACC should decline because its cost of
equity capital has declined. Discuss.
e) How could the capital structure change in question c) be explained based on what
we know from the trade-off theory of capital structure? Assume the debt-to-value
ratio of 20% is the new optimal capital structure for Burberry.
Expert Solution
This question has been solved!
Explore an expertly crafted, step-by-step solution for a thorough understanding of key concepts.
Step by step
Solved in 4 steps with 3 images
Follow-up Questions
Read through expert solutions to related follow-up questions below.
Knowledge Booster
Learn more about
Need a deep-dive on the concept behind this application? Look no further. Learn more about this topic, finance and related others by exploring similar questions and additional content below.Recommended textbooks for you
EBK CONTEMPORARY FINANCIAL MANAGEMENT
Finance
ISBN:
9781337514835
Author:
MOYER
Publisher:
CENGAGE LEARNING - CONSIGNMENT
EBK CONTEMPORARY FINANCIAL MANAGEMENT
Finance
ISBN:
9781337514835
Author:
MOYER
Publisher:
CENGAGE LEARNING - CONSIGNMENT