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.

EBK CONTEMPORARY FINANCIAL MANAGEMENT

14th Edition

ISBN:9781337514835

Author:MOYER

Publisher:MOYER

Chapter14: Capital Structure Management In Practice

Section: Chapter Questions

Problem 21P

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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.

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