Question

Empire Today Inc. has 10 million shares of common stock outstanding, 300,000 shares of 5% preferred stock outstanding, and 7 million of 6.7 percent semiannual bonds outstanding, par value $1,000 each. The common stock currently sells for $85 per share and has a beta of 1.15, the preferred stock currently sells for $103 per share, and the bonds have 20 years to maturity and sell for 93% of par. The market risk premium is 11 percent, T-bills are yielding 2.14 %, and the firm's tax rate is 25.7%.

1) Calculate the firm’s Weighted Average Cost of Capital and explain the meaning of WACC using your calculated solution.

2) The CFO is assessing a potential project which will yield an IRR of 9.3%. The project has the firm level risk. Should the CFO accept the project? Provide your explanations.

Answer 1

1]	The first step is to find the component cost of capital.
	Cost of debt:
	Before tax cost of debt = YTM.
	YTM using a calculator = 7.37%
	After tax cost of debt = YTM*(1-t) = 7.37%*(1-25.7%) =	5.48%
	Cost of preferred capital:
	= 5/103 =	4.85%
	Cost of common stock:
	Per CAPM = risk free rate+beta*market risk premium = 2.14%+1.15*11% =	14.79%
	WACC [based on market value weights]:
	Component cost	Market Value in millions	Weight	Component Cost	WACC
	Debt [7*1000*93%]	$      6,510.00	88.08%	5.48%	4.82%
	Preferred Stock [0.3*103]	$            30.90	0.42%	4.85%	0.02%
	Common Stock [10*85]	$          850.00	11.50%	14.79%	1.70%
		$      7,390.90			6.54%
	WACC = 6.54%
	WACC is the weighted average cost of capital of the firm based on its capital structure. It is the appropriate
	discount rate for projects of similar risk.
2]	As the IRR of the project of 9.3%, is more than the WACC, the project should be accepted. WACC can be used
	as the hurdle rate as the proposed project is of the same risk class as the existing business of the firm.