Question

1. Kramerica Industries has a capital structure consisting of 65% debt and 35% common stock. The company’s CFO has obtained the following information: o The before-tax YTM on the company's bonds is 8.5%. o Kramerica will pay a $3.00 dividend on its common stock and the dividend is expected to grow at a constant rate of 6% a year. The common stock currently sells for $50 a share. o Assume the firm will be able to use retained earnings to fund the equity portion of its capital budget. o The company's tax rate is 35%.

a. What is Kramerica’s WACC?

b.   Two independent projects are available for Kramerica to invest in: Project A has an IRR of 10%, while Project B’s has an IRR of 12.5%. These two projects are equally risky and are of average risk. Which project(s) should Kramerica accept?

Answer 1

a) WACC calculations :

i) Cost of debt = YTM * (1 - Tax rate)

Here, Tax rate = 35% or 0.35

YTM = 8.5% or 0.085

Cost of debt = 0.085 * (1 - 0.35)

Cost of debt = 0.0553 or 5.53%

ii) Cost of equity = (D1 / P) + g

Here, D1 (Expected dividend) = $3

P (Price) = $50

g (growth rate) = 6% or 0.06

Now,

Cost of equity = ($3 / $50) + 0.06

Cost of equity = 0.06 + 0.06

Cost of equity = 0.12 or 12%

iii) WACC = (Weight of debt * Cost of debt) + (Weight of equity * Cost of equity)

Here,

Weight of debt = 65% or 0.65

Weight of equity = 35% or 0.35

Cost of debt = 0.0553

Cost of equity = 0.12

Now,

WACC = (0.65 * 0.0553) + (0.35 * 0.12)

WACC = 0.0360 + 0.0420

WACC = 0.0780 or 7.80%

b) Project A's IRR = 10%

Project B's IRR = 12.50%

WACC = 7.80%

If IRR of the project is higher than it's wacc then project should be accepted.

Here, both projects are providing higher IRR than WACC.

Project A = 10% - 7.80% = 2.20%

Project B = 12.50% - 7.80% = 4.70%

But, Project B is having higher IRR than Project A & higher benefits. Hence, 1st preference should be given to Project B than Project A.