Question

Question 28-31

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 = 0.375 , x c s = 0.625
B)	x d e b t = 0.475 , x c s = 0.525
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 = 5.67 % , k c s = 20.34 %
C)	k d e b t = 6.82 % , k c s = 19.17 %
D)

What is the WACC? (Round to the two decimal places.)
A)	14.24%
B)	13.77%
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, Yes
C)	$53,113, Yes
D)	-$815,175, No

Answer 1

A) Calculation of fraction of each securities that weights of equity & debt:-

Debt to equity = 0.6

That is

Debt to equity = 6/10 = 3/5

Debt to equity = 3/5

Fraction of debt = 3/8

Fraction of equiy = 5/8

Weight of Debt = 3/8 = 37.5%

Weight of Equity = 5/8 = 62.5%

B) calculation of pretax cost of debt & cost of equity:-

Pre tax cost of debt =[ I + (RV - NP)/n] / (RV + NP)/2

here

I = interest amount Np = net proceeds or face value

RV = redemption value n = no. Of years to maturity.

Let us assume face value of bond is $ 100

Interest amount = 100* 8% = 8

RV = 100 * 104% = $ 104. NP = $100. n = 4 years

Pretax cost of debt =[ 8+( 104-100)/4] / (104+100)/2 = 8.82%

Cost of equity= (D​​​​​​1/MVS) + g

D​​​​​​1 = next year expected dividend

MVS = maket values

g = growth rate.

Cost of equity =( $2.50/$15) + 0.025

Cost of equity = 19.167%

C) Calculation of weighted average cost of capital

Weighted average cost of capital = cost of equity * weight of equity + cost of debt* Weight of debt

Weighted average cost of capital = 19.167% * 0.625 + 8.82%* 0.375 * (1-0.30)

Weighted average cost of capital = 14.30%

D) Calculation of NPV

Here the cash flows discounted at WACC

NPV = Present value of cash inflows - present value of cash outflows or initial investment

Initial investment = $ 1.5 million = 1,500,000

Here cash inflows are constant, so we use present value annuity factor to bring into present value.

Present value of cash inflows = cash inflows * PVAF( 6 years,14.30%)

= $175,000 * [ 1- (1.143)-6] / 0.143

= $ 175,000 * 3.856931

Present value of the cash inflows= $ 674,962.922

NPV = $ 674,962.922 - 1,500,000

NPV = ( 825,037.08)

Here NOV is negative value.

Hence the project should not be accepted