Question

Brownfield Inc. has 1,500 bonds outstanding that are selling for $932 each. The bonds carry a 5.0 percent coupon, pay interest semi-annually, and mature in 12.5 years. The company also has 11,500 shares of 6% preferred stock at a market price of $30 per share. This month, the company paid an annual dividend in the amount of $1.50 per share. The dividend growth rate is 4.0 percent. The common stock is priced at $30 a share and there are 35,500 shares outstanding. The company is considering a project that is equally as risky as the overall company. This project has initial costs of $600,000 and operating cash flows of $150,000 a year for the next 10 years and salvage value of $15,000 at the end of 10 years. The initial costs will be financed externally with the flotation costs of 6%. The net working capital (NWC) is expected to increase by $10,000 a year until the end of the project life. The project will be depreciated straight-line to zero over the project’s 10-year life. The tax rate is 20%.

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

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

Answer 1

a]

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

market value of debt = bonds outstanding * market price per bond

market value of preferred stock = shares outstanding * market price per share

market value of common stock = shares outstanding * market price per share

weight of debt = market value of debt / total market value

weight of preferred stock = market value of preferred stock / total market value

weight of common stock = market value of common stock / total market value

cost of equity = (next year dividend / net proceeds per share) + growth rate.

next year dividend = last dividend * (1 + growth rate)

net proceeds per share = price of share - flotation cost

cost of preferred stock = (annual dividend / net proceeds per share)

annual dividend = face value * dividend rate = $50 * 6% = $3

net proceeds per share = price of share - flotation cost

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

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

nper = 12.5*2 (12.5 years to maturity with 2 semiannual coupon payments each year)

pmt = 1000 * 5% / 2 (semiannual coupon payment = face value * annual coupon rate / 2. This is a positive figure as it is an inflow to the bondholder)

pv = -932*(1-6%) (net proceeds per bond = current bond price * (1 - flotation costs). 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 calculated is the semiannual YTM. To calculate the annual YTM, we multiply by 2.

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

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

WACC = 7.50%

b]

cash outflow in year 0 = initial cost

cash inflow in years 1 to 9 = operating cash flow - investment in working capital + depreciation tax shield

depreciation tax shield = annual depreciation * tax rate

annual depreciation = initial cost / life of project in years

cash inflow in year 10 = operating cash flow - investment in working capital + depreciation tax shield + salvage value

In year 10, the entire investment in working capital is recovered, hence the investment in working capital is negative.

NPV is calculated using NPV function in Excel

NPV is $493,990

The project should be accepted because the NPV is positive