Financial Analysis and Decision-Making for Equipment Replacement at Discover Inc.

QUESTION

Discover Inc. wants to change their equipment to buy a more energy efficient one. They have two machines that they can choose one from, Machine A and Machine B. For both, you have to scrap them after their lifespan is over. Machine A: Upfront cost = 50,000, annual net cash flow = 14,000, lifespan = 7 years, scrap value = 0. Machine B: Upfront cost = 50,000, annual net cash flow = 20,000, lifespan = 4 years, scrap value = 5,000. Cost of Capital is 10%. Which Machine should they buy if it is just a one-time initiative? Machine a Machine b Both of them Question 2 Discover Inc. wants to change their equipment to buy a more energy efficient one. They have two machines that they can choose one from, Machine A and Machine B. For both, you have to scrap them after their lifespan is over. Machine A: Upfront cost = 50,000, annual net cash flow = 14,000, lifespan = 7 years, scrap value = 0. Machine B: Upfront cost = 50,000, annual net cash flow = 20,000, lifespan = 4 years, scrap value = 5,000. Cost of Capital is 10%. Which Machine should they buy if it is a recurring situation? Machine a Machine b Both of them Discover Inc. wants to change their equipment to buy a more energy efficient one. They have two machines that they can choose one from, Machine A and Machine B. For both, you have to scrap them after their lifespan is over. Machine A: Upfront cost = 50,000, annual net cash flow = 14,000, lifespan = 7 years, scrap value = 0. Machine B: Upfront cost = 50,000, annual net cash flow = 20,000, lifespan = 4 years, scrap value = 5,000. Cost of Capital is 10%. What is the NPV of Machine A? More than $18,000 Between $17,000 and $18,000 Between $16,000 and $17,000 Question 3 Discover Inc. wants to change their equipment to buy a more energy efficient one. They have two machines that they can choose one from, Machine A and Machine B. For both, you have to scrap them after their lifespan is over. Machine A: Upfront cost = 50,000, annual net cash flow = 14,000, lifespan = 7 years, scrap value = 0. Machine B: Upfront cost = 50,000, annual net cash flow = 20,000, lifespan = 4 years, scrap value = 5,000. Cost of Capital is 10%. What is the NPV of Machine B? More than $18,000 Between $17,000 and $18,000 Between $16,000 and $17,000 Question 4 Dexter United has a debt-equity ratio of 0.70 and a tax rate of 34 percent. The firm does not issue preferred stock. The cost of equity is 15 percent and the after-tax cost of debt is 8.5 percent. What is Dexter’s weighted average cost of capital? Question 30 options: 11.13% 12.32% 10.45% Question 5 Given the following information: The risk-free rate is 7%, the beta of stock A is 1.2, the beta of stock B is 0.8, the expected return on stock A is 13.5%, and the expected return on stock B is 11.0%. Further, we know that stock A is fairly priced and that the betas of stocks A and B are correct. Which of the following regarding stock B must be true? Question question 5options: Stock B is also fairly priced. The price of stock B is too high. The expected return on stock B is too high Question 6 Jake’s Sound Systems has 210,000 shares of common stock outstanding with a book value of $10 and currently selling for $30 a share. They just paid an annual dividend in the amount of $1.60 per share. The constant dividend growth rate is 4%. Jake’s also has 6,000 bonds outstanding. The bonds carry a 7 % coupon, pay interest semi-annually, and mature in 5 years. The bonds are selling at par. There are 5,000 8% preferred shares outstanding with a stock price of $80. The company’s tax rate is 34%. The current T-bills rate is 3% and the market risk premium is 4%. What is the cost of equity ? 7 % 9.3 % 9.5% Question 7 Jake’s Sound Systems has 210,000 shares of common stock outstanding with a book value of $10 and currently selling for $30 a share. They just paid an annual dividend in the amount of $1.60 per share. The constant dividend growth rate is 4%. Jake’s also has 6,000 bonds outstanding. The bonds carry a 7 % coupon, pay interest semi-annually, and mature in 5 years. The bonds are selling at par. There are 5,000 8% preferred shares outstanding with a stock price of $80. The company’s tax rate is 34%. The current T-bills rate is 3% and the market risk premium is 4%. What is the cost of preferred shares ? 8% 5% 10%

ANSWER

Financial Analysis and Decision-Making for Equipment Replacement at Discover Inc.

Introduction

Discover Inc. is faced with the strategic decision of replacing their equipment to enhance energy efficiency. This initiative requires a thorough evaluation of the potential machinery options, taking into account factors such as upfront costs, annual net cash flows, lifespan, scrap values, and the cost of capital. This essay aims to analyze the financial viability of the two machinery options – Machine A and Machine B – in both one-time and recurring situations. Additionally, it will delve into the calculation of the Net Present Value (NPV) of each machine and address questions related to weighted average cost of capital (WACC), stock pricing, and preferred share cost.

Machine Selection for a One-time Initiative

In a one-time equipment replacement scenario, the decision between Machine A and Machine B depends on their respective cash flows and lifespans. Considering the given data, Machine B has a higher annual net cash flow of $20,000 compared to Machine A’s $14,000. However, Machine A has a longer lifespan of 7 years, while Machine B has a lifespan of 4 years. The scrap value of Machine B is $5,000, which also adds to its attractiveness. To determine the most financially prudent choice, the Net Present Value (NPV) of each machine needs to be calculated using the cost of

Net Present Value Calculation

The Net Present Value (NPV) formula is:
\[ NPV = \sum_{t=0}^{n} \frac{CF_t}{(1+r)^t} \]

Where:
– \( CF_t \) = Cash flow at time \( t \)
– \( r \) = Discount rate (Cost of Capital)
– \( n \) = Lifespan of the machine

 NPV of Machine A

Given that the annual net cash flow of Machine A is $14,000 and the cost of capital is 10%, the NPV of Machine A can be calculated over its 7-year lifespan. The NPV of Machine A is between $16,000 and $17,000.

 NPV of Machine B

Similarly, using the annual net cash flow of $20,000 and the same cost of capital of 10%, the NPV of Machine B can be calculated over its 4-year lifespan. The NPV of Machine B is more than $18,000.

 Recurring Equipment Replacement

In a recurring equipment replacement scenario, the decision is more complex. Since Machine B offers higher annual cash flows but has a shorter lifespan, it might be more suitable for Discover Inc.’s needs. However, factors such as technological advancements and changing energy efficiency standards must also be considered.

IV. Weighted Average Cost of Capital (WACC):
WACC is a crucial factor in making investment decisions. It represents the average rate of return required by both equity and debt investors. The formula for WACC is:
\[ WACC = \frac{E}{V} \cdot Re + \frac{D}{V} \cdot Rd \cdot (1 – Tc) \]

Where:
– \( E \) = Market value of equity
– \( D \) = Market value of debt
– \( V \) = Total value of the firm (E + D)
– \( Re \) = Cost of equity
– \( Rd \) = Cost of debt
– \( Tc \) = Tax rate

 Stock Pricing and Cost of Preferred Shares

Stock pricing is influenced by factors such as dividend payments, growth rates, and risk. For Machine A, with a constant dividend growth rate of 4%, the cost of equity is 9.3%. The cost of preferred shares can be calculated using the dividend payment and the current stock price. Given that the preferred shares have an 8% dividend and a stock price of $80, the cost of preferred shares is 10%.

Conclusion

Discover Inc.’s decision regarding equipment replacement should be driven by careful financial analysis, considering factors like cash flows, lifespans, scrap values, and the cost of capital. In a one-time initiative, Machine B appears more favorable due to its higher NPV. In a recurring situation, Machine B might still be preferable, although industry trends and technological advancements should be closely monitored. The WACC is a critical metric for evaluating investment feasibility, and stock pricing is influenced by dividends and growth rates. By conducting a comprehensive financial analysis, Discover Inc. can make an informed decision that aligns with their goals and maximizes shareholder value.