Question

Kirksville Inc. has 1,100 bonds outstanding that are selling for $992 each. The bonds carry a 6.0 percent coupon, pay interest semi-annually, and mature in 7.5 years. The company also has 9,500 shares of 5% preferred stock at a market price of $40 per share. This month, the company paid an annual dividend in the amount of $1.20 per share. The dividend growth rate is 5.0 percent. The common stock is priced at $30 a share and there are 34,500 shares outstanding. The company is considering a project that is equally as risky as the overall company. This project has initial costs of $630,000 and operating cash flows of $80,000 a year for the next 10 years and salvage value of $20,000 at the end of 10 years. The net working capital (NWC) is expected to increase by $10,000 a year until the end of the project life. All the NWCs will be recovered when the project is completed. The project will be depreciated straight-line to zero over the project’s 10-year life. The tax rate is 21%.

(a) What is Kirksville’s weighted average cost of capital?

(b) What is the net present value (NPV) of this project? Should you accept the project? Explain why.

(c) What is the internal rate of return (IRR) of this project? Should you accept the project if you apply the IRR decision rule?

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Answer 1

WACC = (weight of debt * cost of debt) + (weight of preferred stock * cost of preferred stock) + (weight of equity * cost of equity)

market value of debt = 992 * $1,100 = $1,091,200

market value of preferred stock = 9500 * $40 = $380,000

market value of equity = 34,500 * $30 = $1,035,000

total market value = $1,091,200 + $380,000 + $1,035,000 = $2,506,200

weight of debt = $1,091,200 / $2,506,200 = 0.435

weight of preferred stock = $380,000 / $13,470,000 = 0.152

weight of equity = $1,035,000 / $13,470,000 = 0.413

cost of debt = YTM of bond * (1 - tax rate)

YTM is calculated using RATE function in Excel with these inputs :

nper = 7.5*2 (7.5 years to maturity with 2 semiannual coupon payments each year)

pmt = 1000 * 6% /2 (semiannual coupon payment = face value * annual coupon rate / 2. this is a positive figure as it is an inflow to the bondholder)

pv = -992 (current bond price . this is a negative figure as it is an outflow to the buyer of the bond)

fv = 1000 (face value of the bond receivable on maturity. this is a positive figure as it is an inflow to the bondholder)

the RATE is calculated to be 3.07%. This is the semiannual YTM. To calculate the annual YTM, we multiply by 2. Annual YTM is 6.13%

cost of debt = YTM * (1 - tax rate)

cost of debt = 6.13% * (1 - 21%) ==> 4.85%

cost of preferred stock = dividend / current price = $5 / 40 = 12.50%

cost of equity (Gordon model) = (next year dividend / current share price) + constant growth rate

cost of equity (Gordon model) = (($1.20 * 1.05) / $40) + 0.05 = 8.15%

cost of equity = 8.15%

WACC = (0.435 * 4.85%) + (0.152 * 12.50%) + (0.413 * 8.15%) ==> 7.37%

NPV is calculated using NPV function in Excel. NPV is -$299,6964

The project should not be accepted as per NPV rule as the NPV is negative

IRR is calculated using IRR function in Excel. IRR is -11.35%

The project should not be accepted as per IRR rule as the IRR is negative