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In: Finance
Kirksville Inc. has 1,500 bonds outstanding that are selling for $932 each. The bonds carry a...
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%.
(a) (15 points) What is Kirksville’s weighted average cost of capital?
(b) (10 points) What is the net present value (NPV) of this project? Should you accept the project? Explain why.
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Expert Solution
| Kirksville Inc | ||||
| a | Calculation of WACC for the project | |||
| Assuming that the flotaion cost is applicable for all types of capital | ||||
| as nothing has been specified . | ||||
| Debt : | ||||
| YTM = [Annual interest +(Face value-market price)/n]/(Face value +2*market price)/3 | ||||
| Annual Interest =1000*5%= | 50 | |||
| Years for Maturity n= | 12.5 | |||
| Face value | 1000 | |||
| Realizable Market Price less floatation=932*(1-6%)= | 876.08 | |||
| Market value of 1500 bonds @932= | 1,398,000 | |||
| YTM=[50+(1000-876.08)/12.5]/(1000+2*876.08)/3 = | ||||
| YTM =6.53% | ||||
| Tax rate =20% | ||||
| So Post Tax cost of bond =6.53%*80%= | 5.22% | |||
| Preferred share | ||||
| Realizable Market Price less floatation=30*(1-6%)= | 28.2 | |||
| Annual dividend | 1.5 | |||
| Cost of Preferred stock=1.5/28.2= | 5.32% | |||
| no of Pref shares outstanding | 11500 | |||
| Market Value of Preferred shares @30= | 345,000 | |||
| Equity : | ||||
| Market Value of 35500 stock @30= | 1,065,000 | |||
| P0=30, | ||||
| Div growth rate =g=4% | ||||
| Floation cost =f=6% | ||||
| D0=1.5 | ||||
| D1=1.5*1.04=1.56 | ||||
| Cost of Equity=k=[D1/P0(1-f)] +g | ||||
| k=1.56/28.2 +4% | ||||
| k=5.53% +4%=9.53% | ||||
| So cost of equity =9.53% |
| WACC | ||||
| Type of capital | Market Value | Weight of Market Value | Post tax cost of Capital | Weighted cost of Capital |
| Debt | 1,398,000 | 49.79% | 5.22% | 2.60% |
| Preferred stock | 345,000 | 12.29% | 5.32% | 0.65% |
| Equity | 1,065,000 | 37.93% | 9.53% | 3.61% |
| Total | 2,808,000 | 100.00% | 6.87% | |
| So WACC for the capital required for the project is 6.87% |
| Ans b. | ||||
| NPV Calculation | Year 0 | PV Factor/ PV annuity factor @6.87% | PV Of Cash flows | |
| Initial Investment | (600,000) | - | ||
| Increase in NWC | (10,000) | - | ||
| a | Total Initian Investment | (610,000) | 1 | (610,000) |
| Cash flow from Operations | - | |||
| Incremental Operating cash flow | 150,000 | |||
| Depreciation by SL | 60,000 | |||
| EBT | 90,000 | |||
| Tax @20% | 18,000 | |||
| PAT | 72,000 | |||
| Add back depreciation | 60,000 | |||
| b | Total Operating Cash flow | 132,000 | 7.0660 | 932,712 |
| Terminal Cash flow | ||||
| Return of NWC | 10,000 | |||
| Salvage value after tax =15000*80%= | 12,000 | |||
| c | Total Terminal value cash flow | 22,000 | 0.5146 | 11,321 |
| TotalPV of all cash flows | 334,033 | |||
| So NPV of the project is $334,033 |
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