Question

ITT 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. What is ITT's weighted average cost of capital?

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

Please give the explanation and formula!

Answer 1

Part (1)

Pre tax cost of debt = Kd = 2 x RATE (Nper, PMT, PV, FV) = 2 x RATE (2 x 12.5, 5%/2 x 1000, -932, 1000) = 5.77%

Cost of preferred stock = 6% (given)

Cost of common equity = D1/P + g = D0 x (1 + g) / P + g = 1.5 x (1 + 4%) / 30 + 4% = 9.20%

Please see the table below:

Instrument	Price	Number	Market Value	Weight	Pre tax cost	Tax rate	Post tax cost	Wtd average cost
	P	N	MV = P x N	w = MV/Total MV	K	T	K* = K x (1 - T)	w x K*
Bonds	932	1,500	1,398,000	49.79%	5.77%	20%	4.62%	2.30%
Preferred Stock	30	11,500	345,000	12.29%	6%		6.00%	0.74%
Common Stock	30	35,500	1,065,000	37.93%	9.200%		9.20%	3.49%
Total			2,808,000					6.53%

Hence, ITT's weighted average cost of capital = 6.53%

Part (2)

The initial costs will be financed externally with the flotation costs of 6%.

Hence, discount rate = WACC / (1 - F) = 6.53% / (1 - 6%) = 6.94%

Please see the table below. All financials are in $. Please see the second column to understand the mathematics. The last row colored in yellow contains your answer. Adjacent cell in blue shows the excel formula used to get the answer.

The net present value (NPV) of this project = $  392,096.75

We should accept the project as it has a positive NPV