Rolls Royce Corporation is a manufacturer and dealer of hardware components and engines used in commercial planes. Currently, the directors are considering replacement of a major production equipment used to manufacture the hardware components. The equipment will cost $250,000,000 and has a capacity to produce 5,000 hardware components per year for the next ten years. The variable cost of production is $12,500 per component and a selling price of $40,000 per component. Fixed cost per year will be $25,000,000 for the foreseeable future. Roll Royce Corporation will need $20,000.00 net working capital per year to undertake this investment. The entity’s weighted average cost of capital is 15%. Inflation in the economy is expected to be 5% for the foreseeable future. Depreciation is provided for on a straight-line basis and taxes are paid at the marginal rate of 30%. The directors may expand the investment if it is viable in the second year and the volatility of cash flow is 30% and the risk-free rate is at least equal to the rate of inflation. The directors also decided to finance fifty percent of the investment with debt finance by issuing ten-year 12% coupon bonds redeemable at 10% premium. Rolls Royce forecast earnings per share have been estimated at $48 and dividend of $18 per share will be paid to shareholders. Cost of equity before debt financing has been estimated at 18% using the capital asset pricing model. Divided has been growing at a constant rate of 6% per year and is expected to remain so for the foreseeable future. A one-year call option on the shares has an exercise price of $180 and the options will be valued using discrete time option pricing model.
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