Question

Q 28

Your company is considering an expansion project that will cost $1.5 million. The project will generate after-tax cash flows of $175,000 per year for 6 years. Your company is expected to pay an annual dividend in the amount of $2.50 per share next year and the current price of share is $15. The dividend growth rate is 2.5%. The bonds carry an 8 percent coupon, pay interest annually, and mature in 4 years. The bonds are selling at 104% of face value. The firm is in the 30% tax bracket and the target debt-equity (D/E) ratio is 0.6. What is the NPV for the project and should you accept the project? Calculate the cost of debt using EAR (Effective Annual interest Rate).

What is the fraction of each securities? (Round to the three decimal places.)
A)	x d e b t = 0.475 , x c s = 0.525
B)	x d e b t = 0.375 , x c s = 0.625
C)	x d e b t = 0.525 , x c s = 0.475
D)

What is the pre-tax cost of debt and cost of common equity? (Round to the two decimal places.)
A)	k d e b t = 4.54 % , k c s = 23.68 %
B)	k d e b t = 6.82 % , k c s = 19.17 %
C)	k d e b t = 5.67 % , k c s = 20.34 %
D)

What is the WACC? (Round to the two decimal places.)
A)	13.77%
B)	14.24%
C)	16.43%
D)	17.65%

What is the NPV of this project and should you invest in this project? (Round to the nearest dollar.)
A)	-$53,113, No
B)	-$815,175, No
C)	$53,113, Yes
D)	$815,175, Yes

Answer 1

1.B is correct

Given D/E=0.6

To find out the weights of debt and equity,

D+E=0.6+1=1.6

Weight of debt=0.6/1.6=0.375

Weight of equity=1/1.6=0.625

2. B is correct

Cost of debt of a bond is nothing but its YTM

This we can find using Yield function in excel

YIELD(Settlement date,maturity,rate,pr,redemption,frequency,[basis])

Given 4 year maturity, so we should take two dates (for example settlement date=date of issue of bond and maturity is date of bond expires)

rate coupon=8%

pr=trading price=104

redemption=face value=100

frequency= coupon payments frequency in a year=1

basis=you can give 0

YIELD(01-Jan-2020,31-Dec-2023,8%,104,100,1,0)

6.82% which is cost of debt

Cost of equity can be found by gorson growth model

P0=D1/(r-g)

r=(D1/P0)+g

r=(2.5/15)+2.5%

r=19.17%

3. A=13.77%

WACC= (wieight of debt*cost of debt*(1-tax rate))+(weight of equity*cost of equity)

=(0.375*(6.82%)*(1-30%))+(0.625*19.17%)

=13.77%

4. NPV=-$815,175 and No, we should accept this project as NPV is negative

NPV(13.77%,6 year cash inflows)+(-1,500,000) with excel

Manual calculation is as below

NPV= (Present value of after tax cash inflows)- initial cash outflow

NPV=(($175,000/1.1377)+((175,000/(1.1377)^2)+(175,000/(1.1377)^3)+(175,000/(1.1377)^4)+(175,000/(1.1377)^5)+(175,000/(1.1377)^6))-$1500000

NPV=-$815,175