Question

1. Cranberry Inc. is considering the production of a new smart phone that will require an initial investment of $2 million. The project is expected to yield cash flows for 5 years. The firm expects to sell 5,500 units per year for a net cash flow of $140 each for the first 2 years. After the first two years of sales, their main competitor is expected to launch a new smart phone. As a result, two things could happen:

• Sales for the rest of the project could decline to 4,000 units per year (30% probability), OR
• Sales for the rest of the project will decline to 3,000 units per year (70% probability)
• Assume that Cranberry pays no taxes and that the relevant cost of capital is equal to 15%.

Required

1. What is the NPV of the project?
2. Cranberry has the option to abandon the project after two years. If Cranberry decides to abandon the project, the firm can salvage the assets for $1,300,000 at the end of year 2. Compute the NPV of the project with this option and compute the value of the option.

1. A firm's market values of equity and debt are $750,000 and $250,000, respectively. In addition, the firm's book values of equity and debt are $700,000 and $300,000, respectively. The before-tax cost of debt = 6%; RF = 4%; beta (13) = 0.8; the market risk premium = 10%; and the tax rate = 20%.

Calculate the WACC (weighted average cost of capital).

2. A firm has the following capital structure based on market values: equity 65 percent and debt 35 percent. The current yield on government T-bills is 2 percent, the expected return on the market portfolio is 10 percent, and the firm's beta is approximated at 2.1. The firm's common shares are trading at $25, and the current dividend level of $3 per share is expected to grow at an annual rate of 4 percent. The firm can issue debt at a 3 percent premium over the current risk-free rate. The firm's tax rate is 40 percent, and the firm is considering a project to be funded out of internally generated funds that will not alter the firm's overall risk. This project requires an initial investment of $12 million and promises to generate net annual after-tax cash flows of $2 million perpetually.

Should this project be undertaken?

3. A firm wishes to raise funds in the following proportions: 20 percent debt, 20 percent preferred shares and 60 percent common equity. Assume the cost of internally generated funds is 15 percent. Annual after-tax cost of debt is 5.86%. Cost of preferred equity is 6.12%. It believes all of the common equity component can be raised using internally generated funds.

• Find the WACC
• Determine the marginal cost of capital (MCC) if the firm must raise funds beyond a break point (i.e. break point is the maximum investment in which all targeted equity can be financed internally). Assume the cost of new common equity issues is 20 percent.
• Explain the concept of WACC and MCC. In what circumstances would you use one over the other?

Answer 1

1. Equity= 750000

Debt= 250000

Cost of equity= R(f)+ β{E(m)-R(f)}

• R(f) = Risk-Free Rate of Return= 4%
• β = Beta of the stock= 0.8
• [E(m)-R(f)] = equity risk premium= 10%

Cost of equity= 0.04 + 0.8(0.10)

= 0.04 + 0.08= 0.12 or 12%

Cost of debt = 6%

Tax = 20%

WACC= {kd (1-t)*debt/ debt+ equity}+ {ke*equity/debt+ equity}

= 0.06* (1-0.20) * 25/100 + 0.12*75/100

= 0.012 +0.09

=0.102 or 10.20%

2. Equity=65%

Debt= 35%

Current risk free rate of debt=2%

Cost of debt of the firm = 3+ 2 = 5%

Cost of equity = (DPS/MPS)+g

DPS= Dividend per share. MPS= Market price per share, g= growth rate of dividend

DPS= 3

MPS= 30

G= 4%

Cost of equity= 3/30 +0.04

= 0.1 +0.04

= 0.14 or 14%

WACC= {kd (1-t)*debt/ debt+ equity}+ {ke*equity/debt+ equity}

Wacc= 0.05*0.6*0.35 + 0.14* 0.65

= 0.0105 + 0.091.

= 0.1015 = 10.15%

Now the cost of project= $12 mil

Cash flow= 2 mil

Present value of cash flow= cash inflow/ wacc

= 2000000/0.1015

=19,704,433.50

As the present value of inflow > the present value of cash outflow

We should accept the project.