Question

Grand Co. is planning on establish a project of new line product for 4 years that can help to enhance the income of the company in the next few years. The project is estimated required approximately $3,000,000 for the initial investment. The total cash outflows each year are estimated $1,000,000; $900,000; $700,000 for the year 1, 2 and 3. The total cash inflows are forecasted $500,000; $4,500,000; $6,600,000; and $4,000,000, respectively, during the period of the project.

In order to implement the project, the company used the following capital structure:

1. Issuing bonds: 5,000 coupon bond, with 10% of coupon rate that paying annually for 5

years, the YTM of the bonds is estimated with 9%.

2. Issuing Preferred stock: 2,000 preferred stock with 20% of preferred with par value of

$150. Required rate of preferred is supposed 12%.

3. Issuing Common stock: 10,000 common stocks. The company plans to pay $5 dividend

next year for each stock. And the growth rate of dividend is constant with 9% each year.

Company data: Tax is 30%; beta of the company is 1.5

Market data: Average market return is 13%; Treasury bill rate is 5%.

Requirement:

a. Calculate the price of all company’s securities. Assuming that the selling prices of the the price investors are willing to pay.

b. Calculate the weighted average cost of capital of the company.

c. How do you think about the feasibility of the project?

Answer 1

Part (a)

Face value of the bonds not given. I have assumed the same to be $ 1,000 which is a customary assumption consistent with debt capital markets.

Price of the bond, Pb = - PV (Rate, Nper, PMT, FV) = - PV (9%, 5, 10% x 1000, 1000) = 1,038.90

Price of the preferred stock, Pp = annual dividend / required return = 20% x 150 / 12% = 250.00

Cost of common equity, Ke = Rf + Beta x (Rm - Rf) = 5% + 1.5 x (13% - 5%) = 17.00%

Price of common stock, Pe = D1 / (Ke - g) = 5 / (17% - 9%) = 62.50

Part (b)

Please see the table below. All financials are in $. Please see the second row to understand the mathematics. The cells colored in yellow contain your answer.

Instrument	Price	Number	Value	Weight	Pre tax cost	Post tax cost	Weighted cost
	P	N	V = P x N	w = V / total V	K	K* (see note below)	w x K*
Debt	1,038.90	5,000.00	5,194,482.56	82.20%	9.00%	6.30%	5.18%
Preferred stock	250.00	2,000.00	500,000.00	7.91%	12.00%	12.00%	0.95%
Common equity	62.50	10,000.00	625,000.00	9.89%	17.00%	17.00%	1.68%
Total			6,319,482.56	100.00%		WACC =	7.81%

*Note: Post tax cost = K x (1 - T) = 9% x (1 - 30%) = 6.30% for debt; for other instruments, post tax cost = pre tax cost.

Part (c)

Year, n	Linkage	0	1	2	3	4
Initial cost	A	-3,000,000
Inflow	B		500,000	4,500,000	6,600,000	4,000,000
Outflow	C		-1,000,000	-900,000	-700,000
Net cash flows	D = A + B + C	-3,000,000	-500,000	3,600,000	5,900,000	4,000,000
WACC	r	7.81%
Discount factor	DF = (1 + r)^(-n)	1.0000	0.9276	0.8604	0.7981	0.7402
PV of cash flows	E = D x DF	-3,000,000.00	-463,782.22	3,097,352.83	4,708,518.48	2,960,985.96
NPV	Sum of all E	7,303,075.06

Since the project has positive NPV, it is a feasible project and should be accepted.