Question

Part A. Assume the cost of equity, preferred stock and debt of JPM Inc are 20%, 15% and 12%, respectively. Their capital structure is 40% equity, 20% preferred stock and 40% debt. What is the weighted cost of capital (WACC) if the tax rate is 40%?

		a. 16.16%
		b. 14.42%
		c. 15.88%
		d. 13.88%

Part B. JPM Inc proposes to borrow $10 million capital to expand their operations, $4 million in bonds and the rest in common stock. They can issue stocks for $43.75 by paying a dividend of $3.50 next year and maintain a growth rate of 8%. They can issue 20-year bonds for $699.07 paying 8% coupon, paid semi-annually. What is the weighted cost of capital assuming a tax rate of 35%.

		a. 11.16%
		b. 12.72%
		c. 14.40%
		d. 16%

Part C. JPM Inc is planning to invest $1,000,000 in new equipment that will increase its after-tax cash flows by $300,000 for the next five year. Its capital structure is 50% debt and 50% equity. If the cost of equity is 18% and after-tax cost of debt is 8%, should they undertake the project?

		a. No, NPV = -$61,848.69
		b. No, NPV = -$17,711.90
		c. Yes, NPV = $29,924.29
		d. Yes, NPV = $55,169.33

Answer 1

A) WACC = Portion of debt*Cost of debt*(1-Tax rate) + Portion of preferred stock*Cost of preferred stock + Portion of equity*Cost of equity

= 0.4*12%*(1-0.4) + 0.2*15% + 0.4*20%

= 13.88%

Ans: 13.88%

B) Price of stock = Dividend next year/(Cost of equity - Growth rate)

43.75 = 3.5/(Cost of equity - 0.08)

Cost of equity - 0.08 = 3.5/43.75 = 0.08

Cost of equity = 0.08 + 0.08 = 16%

Calculating cost of debt:

NUmber of periods = 20 * 2 = 40 (because this is a semi-annual bond)

PMT (Payment per period) = 8%/2 * 1000 = $40

PV = $699.07

FV = $1000

Using Rate function in excel:

YTM =RATE(40,40,-699.07,1000)*2 = 12%

Therefore, cost of debt = 12%

WACC = Portion of debt*Cost of debt*(1-Tax rate) + Portion of preferred stock*Cost of preferred stock + Portion of equity*Cost of equity

WACC = (4/10)*12%*(1-0.35) + 0*0 + (6/10)*16% = 12.72%

Ans: 12.72%

C)

WACC = Portion of debt*Cost of debt*(1-Tax rate) + Portion of preferred stock*Cost of preferred stock + Portion of equity*Cost of equity

Here after-tax cost of debt is given

WACC = 0.5*8% + 0*0 + 0.5*18% = 13%

NPV = -$1,000,000 + $300,000/1.13 + $300,000/1.13² + $300,000/1.13³ + $300,000/1.13⁴ + $300,000/1.13⁵

= $55,169.33

Ans: d. Yes, NPV = $55,169.33