Question

Assume the market value of Fords' equity, preferred stock and debt are $7 billion, $4 billion and $10 billion respectively. Ford has a beta of 1.4, the market risk premium is 6% and the risk-free rate of interest is 4%. Ford's preferred stock pays a dividend of $3 each year and trades at a price of $25 per share. Ford's debt trades with a yield to maturity of 8.5%. Currently, Ford is considering investing in a new project with an upfront cost of $400 million. The project will generate an incremental free cash flow of $50 million in the first year and this cash flow is expected to grow at an annual rate of 3% forever. If the firm's tax rate is 35%, what is the best estimate of value of this project?

		A) $446.3 million
		B) $436.65 million
		C) $431.3 million
		D) $426.45 million
		E) Need more information

Answer 1

Cost of equity using CPAM = Risk free rate + beta ( amrket risk premium)

Cost of equity = 0.04 + 1.4 ( 0.06 )

Cost of equity = 0.124 or 12.4

After tax cost of debt = 0.085 ( 1 - 0.35 )

After tax cost of debt = 0.05525 or 5.525%

Cost of preferred stock = Annual dividend / Price

Cost of preferred stock = 3 / 25

Cost of preferred stock = 0.12 or 12%

Total capital structure = 7 billion + 4 billion + 10 billion

Total capital structure = 21 billion

Weigth of equity = 7 / 21 = 0.3333

Weight of preferred stock = 4 / 21 = 0.1905

Weight of debt = 10 / 21 = 0.4762

WACC = Weight of equity * cost of equity + weight of preferred stock * cost of preferred stock + weight of debt * cost of debt

WACC = 0.3333 * 0.124 + 0.1905 * 0.12 + 0.4762 * 0.05525

WACC = 0.041329 + 0.02286 + 0.02631

WACC = 0.090499 or 9.0499%

Value of project = Cash flow / WACC - growth rate

Value of project = (50 / 0.090499 - 0.03) - 400

Value of project = (50 / 0.060499) - 400

Value of project = $426.45 million