Question

Kirksville 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%.

1. 15 points) What is Kirksville’s weighted average cost of capital?

2. (10 points) What is the net present value (NPV) of this project? Should you accept the project? Explain why.

Answer 1

a. The cost of debt is calculated by employing the RATE function in excel as follows:

PV =$932

FV = $1,000

PMT = $1,000 X 2.5% = $25

NPER = 12.5 years X 2 = 25

Therefore, RATE (NPER, PMT, -PV, FV, 0) = RATE (25, 25, -932, 1000, 0) = 2.89%.

As the bond is semi-annual, annual cost of bond = 2.89% X 2 = 5.77%.

Therefore, after tax cost of bond = 5.77% X (1-.20) = 4.62%.

Cost of preference capital is 6% (given)

Cost of equity capital is computed as below:

D₁ / P₀ + G = ($1.50 x 104%) / $30 + 4% = $1.56 / $30 + 4%= 9.20%.

The weights of different components of capital are computed as below:

Market value of debt capital = 1,500 X $932 = $13,98,000

Market value of preferred capital = 11,500 X $30 = $345,000

Market value of equity capital = 35,500 X $30 = $10,65,000

Therefore, total capital = $13,98,000 + $345,000 + $10,65,000 = $28,08,000.

Weight of debt capital = $13,98,000 / $28,08,000 = 0.50

Weight of preferred capital = $345,000 / $28,08,000 = 0.12

Weight of equity capital = $10,65,000 / $28,08,000 = 0.38

Hence, weighted average cost of capital (WACC) = Respective costs of capital X respective weights = 4.62% X 0.50 + 6% X 0.12 + 9.20% X 0.38 = 6.53%.

b. Revised cost of capital = WACC / (1- Floatation cost) = 6.53% / (1- 0.06) = 6.94%.

	1	2	3	4	5	6	7	8	9	10
Operating cash flows	$1,50,000	$1,50,000	$1,50,000	$1,50,000	$1,50,000	$1,50,000	$1,50,000	$1,50,000	$1,50,000	$1,50,000
(+) Salvage value	$0	$0	$0	$0	$0	$0	$0	$0	$0	$15,000
Total cash flows	$1,50,000	$1,50,000	$1,50,000	$1,50,000	$1,50,000	$1,50,000	$1,50,000	$1,50,000	$1,50,000	$1,65,000
(-) Increase in working capital	$10,000	$10,000	$10,000	$10,000	$10,000	$10,000	$10,000	$10,000	$10,000	$10,000
(-) Depreciation	$60,000	$60,000	$60,000	$60,000	$60,000	$60,000	$60,000	$60,000	$60,000	$60,000
EBIT	$80,000	$80,000	$80,000	$80,000	$80,000	$80,000	$80,000	$80,000	$80,000	$95,000
(-) taxes @ 20%	$16,000	$16,000	$16,000	$16,000	$16,000	$16,000	$16,000	$16,000	$16,000	$19,000
Cash flow after taxes	$64,000	$64,000	$64,000	$64,000	$64,000	$64,000	$64,000	$64,000	$64,000	$76,000
(+) Depreciation	$60,000	$60,000	$60,000	$60,000	$60,000	$60,000	$60,000	$60,000	$60,000	$60,000
Free cash flows	$1,24,000	$1,24,000	$1,24,000	$1,24,000	$1,24,000	$1,24,000	$1,24,000	$1,24,000	$1,24,000	$1,36,000
Present value discounting factor [1 / (1 + 6.94%)^n], n= 1,2,...10	0.94	0.87	0.82	0.76	0.71	0.67	0.63	0.58	0.55	0.51
Present value of free cash flows (Free cash flows X Discount factor)	$1,15,951	$1,08,425	$1,01,387	$94,806	$88,652	$82,898	$77,517	$72,485	$67,780	$69,514
Sum of present values	$8,79,415
(-) Initial investment	$6,00,000
NPV	$2,79,415

As the NPV is positive, the project should be accepted.