Question

Your power plant on Gilligan’s Island is producing too much air pollution. The professor gives you three choices for dealing with this problem: You can pay a pollution tax (Carbon Offsets) onetime of $13,000,000 immediately. You can close the plant and install a power cable from the mainland to the Island. That will cost you $1,000,000 at the end of this year, $3,000,000 at the end of next year and then $750,000 forever for maintenance. You can retrofit the plant with scrubbers to reduce the emissions to make the plant green. That will cost $7.5m at the end of this year and $100,000 for 50-years for maintenance. Assume that the cost of generating power on the mainland is approximately the same as the cost of generating power at your Gilligan’s Island plant. Assume, this comes as a surprise to you and you have not saved any money in reserves and you need to raise capital. Additional information is that market has a 12 percent market risk premium on the power plant with the risk free rate being 5 percent with a company tax rate of 35 percent. Current total raised capital at the power plant: (This will help you calculate the WACC) Debt – 7,000 outstanding bonds, at 7.5% coupon and 20 years to maturity. These bonds pay interest semiannually and quoted price of 108 percent of par. Common Stock -180,000 shares outstanding, selling for $50 per share: Beta .90 CAPM is .118 or 11.8% Preferred Stock – 8,000 shares of 5.5 percent preferred stock outstanding, currently selling for $95.00 per share. Choose the best option for Gilligan's Island. Calculate the WACC

Answer 1

Formula sheet

A	B	C	D	E	F	G	H	I	J
2
3
4		Calculation of cost of equity:
5		As Per CAPM, Expected rate of return can be calculated as
6		r(E) = rf + ?*(rm-rf)
7		Using the Following data
8		Beta (?)	0.9
9		Risk free rate ( rf )	0.05
10		Market Risk Premium (rm-rf)	0.12
11
12		Expected rate of return can be calculated as follows:
13		Expected rate of return	= rf + ?*(rm-rf)
14			=D9+D8*D10	=D9+D8*D10
15
16		Hence Cost of Equity is	=D14
17
18		Calculation of Cost of preferred stock:
19		Face Value of Preferred Stock	100
20		% dividend on preferred stock	0.055
21		Annual Dividend of preferred stock	=D20*D19
22		Current Price	95
23		Floatation cost (F)	0
24		Cost of preferred stock	=Dividend/Current Price*(1-F)
25			=D21/(D22*(1-D23))	=D21/(D22*(1-D23))
26
27		Hence cost of Preferred Stock is	=D25
28
29		Calculation of cost of debt:
30		Cost of debt will be the yield to maturity of the bond can be calculated as follows:
31		Time to maturity	20	years
32		Annual coupon rate	0.075
33		Par value	1000
34		Market Price	=D33*108%
35		Semi-Annual coupon	=D33*D32/2
36		Semi-Annual Period	=D31*2
37		Floatation cost	0
38		Net proceed by issuing bond	=D34*(1-D37)
39		Rate(nper,pmt,PV, [fv],type) function of excel can be used to find the yield to maturity as follows:
40		NPER	=D36
41		PMT	=D35
42		PV	=-D38
43		FV	=D33
44
45		Yield to maturity of the bond	=2*RATE(D40,D41,D42,D43)	=2*RATE(D40,D41,D42,D43)
46
47		Hence Cost of debt is	=D45
48
49		Calculation of Weight of Common Stock, Preferred stock and Debt:
50		Market Value of Common Equity	=Number of common shares * Market Value of common shares
51
52		Using the following data
53		Number of common shares outstanding	180000
54		Share Price	50
55		Market Value of Common Equity	=Number of shares * Market Value of shares
56			=D54*D53
57
58		Market Value of Debt	=Number of Bonds * Market Price of Bonds
59
60		Using the following data
61		Number of Bonds	7000
62		Price of Bonds	=D34
63		Market Value of Debt	=Number of Bonds * Market Price of Bonds
64			=D62*D61
65
66		Market Value of Preferred shares	=Number of preferred shares * Market Value of preferred shares
67		Number of preferred shares outstanding	8000
68		Share Price	=D22
69		Market Value of Preferred shares	=Number of preferred shares * Market Value of preferred shares
70			=D68*D67
71		Market Value of firm	=D56+D64+D70	=D56+D64+D70
72		Weight of common equity, w(E)	=Market Value of common equity / Market Value of Firm
73			=D56/D71
74
75		Weight of debt, w(D)	=Market Value of debt / Market Value of Firm
76			=D64/D71
77
78		Weight of preferred share, w(P)	=Market Value of preferred shares / Market Value of Firm
79			=D70/D71
80
81		Calculation of WACC
82		Source of capital	Capital Structure	Cost
83		Debt	=D76	=D47
84		Common Stock	=D73	=D16
85		Preferred Stock	=D79	=D27
86
87		Tax Rate	0.35
88
89		WACC	= r(E) × w(E) + r(P) × w(P)+r(D) × (1 – t) × w(D)
90			=D84*E84+D85*E85+D83*E83*(1-D87)	=D84*E84+D85*E85+D83*E83*(1-D87)
91
92		Hence WACC of the firm is	=D90
93