Question

Case Two (22 pts) Given the following information for Bajor Co.:

Debt: Bajor’s long-term debt capital consists of bonds with 6.250 percent coupon rate (semiannual coupon payments), 9 years time-to-maturity, and current price of 106.61 percent of its par value (i.e., price = 106.61 relative to full amount redemption par of 100).

Preferred stock: Bajor has not issued any preferred stocks.

Common stock (equity):  Bajor’s equity capital consists of common stocks with the most recent annual dividend of $0.92 per share, and a current stock price of $14 per share.  According to online data sources, Bajor’s long-term dividend growth (for next 5-Year average, per annum) g = 4.5% per year.  The “risk-free” Treasury bill return is 3.8%; the market expected return for the stock market on average is 12.3%; and Bajor’s systematic risk (Beta) is 0.71.

Taxes: The applicable federal-plus-state corporate tax rate for Bajor is 25.7 percent.

Capital weight: Bajor’s “Market Cap” amounts to $18.23 billion, and “Total Debt” amounts to $14.44 billion. You can use such data to estimate the capital weights for equity and debt, respectively (We and Wd).

Time constraint: For any investment projects, Bajor are required by her investors to recover its initial cost within no more than 6 years.

Q1: What is Bajor’s pretax cost of debt Rd, cost of equity Re, and WACC, respectively? (Hint: For the best estimate of cost of equity Re, you must apply both CAPM and Dividend Growth Model and then average the two estimates.)

Q2: There are three investment projects available to Bajor: Project A costs $12 million to invest today, and then provides “cash inflow from assets” of $2.50 million per year for the next 7 years. Project B costs $18 million to invest today, and then provides “cash inflow from assets” of $3.30 million per year for the next 8 years. Project C costs $30 million to invest today, and then provides “cash inflow from assets” of $4.25 million per year for the next 10 years.

If Projects A, B & C are mutually exclusive, which project(s) should Bajor accept? (You must apply the three major investment evaluation rules NPV, IRR and Payback)

Q3: If Projects A, B & C are independent, which project(s) should Bajor accept? (You must apply the three major investment evaluation rules NPV, IRR and Payback)

Answer 1

Q 1

Semi annual yield = RATE (Period, PMT, PV, FV) = RATE (2 x 9, 6.25%/2 x 100, -106.61, 100) = 2.6582%

Hence, pre tax cost of debt, Rd = Annual yield = 2 x semi annual yield = 2 x 2.6582% = 5.32%

Common stock:

Cost of equity using CAPM = risk free rate + Beta x market risk premium = 3.8% + 0.71 x (12.3% - 3.8%) = 9.84%

Cost of equity using DDM = D1 / P0 + g = 0.92 x (1 + 4.5%) / 14 + 4.5% = 11.37%

Hence, cost of equity, Re = average of the two values above = (9.84% + 11.37%) / 2 = 10.60%

Market value of debt, D = $ 14.44 bn

Market value of equity, E = $ 18.23 bn

Total capital, C = D + E = 14.44 + 18.23 = 32.67

Tax rate, T = 25.7%

Proportion of debt, Wd = D / C = 14.44 / 32.67 = 44.20%

Proportion of equity, We = E / C = 1 - Wd = 1 - 44.20% = 55.80%

WACC = Wd x Rd x (1 - T) + We x Ke = 44.20% x 5.32% x (1 - 25.7%) + 55.80% x 10.60% = 7.66%

Q - 2

NPV of a project = - C₀ + C/ i x [1 - (1 + i)^-n]

Project	Initial investment	Annual cash flows	Period	Discount rate	NPV	IRR	Payback period (years)
	-C0	C	n	i = WACC	- C0 + C/ i x [1 - (1 + i)-n]	RATE(n, C, -C0, 0)	C0 / C
A	-12	2.5	7	7.66%	1.1680	10.43%	4.80
B	-18	3.3	8	7.66%	1.2101	9.39%	5.45
C	-30	4.25	10	7.66%	-1.0414	6.89%	7.06

Amongst mutually exclusive projects, only one can be selected.

Project B has highest NPV, Project A has highest IRR and Project A has least payback period. If there is a conflict, select the project with highest NPV. Hence, choose Project B.

If projects are independent, the firm should select all the projects with positive NPV. Hence choose the projects A & B.