Question

You have the following information about Burgundy Basins, a sink manufacturer.

Equity shares outstanding		20	million
Stock price per share	$	46
Yield to maturity on debt		7.5	%
Book value of interest-bearing debt	$	385	million
Coupon interest rate on debt		5.1	%
Market value of debt	$	280	million
Book value of equity	$	480	million
Cost of equity capital		13.2	%
Tax rate		35	%

Burgundy is contemplating what for the company is an average-risk investment costing $52 million and promising an annual ATCF of $5.6 million in perpetuity.

a. What is the internal rate of return on the investment? (Round your answer to 2 decimal places.)

b. What is Burgundy's weighted-average cost of capital? (Round your answer to 2 decimal places.)

Answer 1

a)

Calculation of internal rate of return on the investment:

Where IRR , Present value of cash inflows is equal to Present value of cash Outflows.

Let as take X% is the IRR

Present value of Cash Outflows= $ 52000000

Present value of cash inflows = $5600000 perpetually.

A perpetuity is a security that pays for an infinite amount of time. In finance, perpetuity is a constant stream of identical cash flows with no end. The formula to calculate the present value of a perpetuity, or security with perpetual cash flows, is: The basic method used to calculate a perpetuity is to divide cash flows by some discount rate

So Present value of cash inflows= $5600000/x%

Present value of cash inflows = Present value of cash Outflows.

         $5600000/x%                        =     $ 52000000    

                      X%                          = $ 52000000/5600000

                      X%                          = $ 52000000/5600000

                                                          = 9.2857%

So, IRR= 9.2857%

b)

Calculation of weighted-average cost of capital:

Calculating Cost of Debt:

YTM Approach=YTM(1-taxrate)

                                      =7.5%(1-35%)

                               =4.875%

Cost of Equity capital= 13.2%

Equity value     = 20*46= $ 720 million

Market value of Debt= $280 million

Total value= $1000 Million

weighted-average cost of capital : =[(720*13.2%)+(280*4.875%)]/1000

                                                                       = 10.869%

Calculating Cost of Debt:

Debt-Rating Approach:     Coupon rate(1-taxrate)

                                      =5.1%(1-35%)

                                      =3.315%

Cost of Equity capital= 13.2%

Equity value     = 20*46= $ 480 million

Market value of Debt= $ 385 million

Total value= $ 865 Million

weighted-average cost of capital : =[(480*13.2%)+(385*3.315%)]/865

                                                                       = 8.80%