Question

7. TAMU Inc. is evaluating a project which costs $225,000. Currently, TAMU has a beta of 1.5, the market is expected to have a 20% return and the risk-free rate is 5%. The forecasted free cash flows for the next 4 years for this project are $70,000 (FCF1), $100,000(FCF2), 0(FCF3), and $125,000 (FCF4). The project will cease to exist after that. TAMU has a debt/equity ratio of 2/3 and the applicable tax rate is 35%. The cost of debt (before taxes) can be calculated using TAMU’s currently issued bond which has a face value of $1000, yearly paid coupon rate of 10%, 20 years left to maturity and a current price of $1,196.36. What is the cost of equity for TAMU Inc.?        12.00%        18.00%        21.00%        27.50%

Question 8. 8. Continued from Question 7, what is the pre-tax cost of debt (before taxes) for TAMU Inc.?        9.76%        8.00%        11.65%        7.50%

Question 9. 9. Continued from Question 7, what is TAMU’s WACC (after tax)?        11.65%        17.55%        18.58%        20.12%

Question 10. 10. Continued from Question 7, what is the NVP for this project?        -$31,629        -$15,184        $14,446        $28,170

Question 11. 11. Continued from Question 7, what is the IRR of the project?        19.55%        16.51%        15.17%        11.32%

Question 12. 12. Continued from Question 7, what is the MIRR of the project? Assuming that the positive cash inflow from undertaking this project will be reinvested at the after-tax weighted average cost of capital calculated in Question 9.        14.17%        17.28%        19.78%        20.86%

Answer 1

1)

cost of equity using CAPM model = risk free rate + beta ( expected return on market - risk free rate)

Cost of equity = 0.05 + 1.5 ( 0.2 - 0.05)

Cost of equity = 0.275 or 27.5%

2)

Face value = 1,000

Price = 1196.36

number of periods = 20

Coupon payment = 0.1 * 1000 = 100

Pre tax cost of debt using a financial calculator is 8.00%

Keys to use in a financial calculator: PV = -1196.36, FV = 1000, PMT = 50, N = 20 , CPT I/Y

3)

After tax cost of debt = pre tax cost of debt ( 1 - tax rate)

After tax cost of debt = 0.08 ( 1 - 0.35)

After tax cost of debt = 0.052 or 5.2%

Weight of equity = 1 / 1.66666 = 0.600002

weight of debt = 1 - 0.600002 = 0.399998

WACC = weight of debt * cost of debt + weight of equity * cost of equity

WACC = 0.399998* 0.052 + 0.600002* 0.275'

WACC = 0.0208 + 0.165001

WACC = 0.1858 or 18.58%

4)

NPV = present value of cash inflows - present value of cash outflows

NPV = -225,000 + 70000 / ( 1 + 0.1858)¹ + 100,000 / ( 1 + 0.1858)² + 0 + 125,000 / ( 1 + 0.1858)⁴

NPV = -$31,629

5)

IRR is the rate of return tha makes NPV equal to 0

-225,000 + 70000 / ( 1 + r)¹ + 100,000 / ( 1 + r)² + 0 + 125,000 / ( 1 + r)⁴ = 0

From the option let's try 11.32% as a:

-225,000 + 70000 / ( 1 + 0.1132)¹ + 100,000 / ( 1 + 0.1132)² + 0 + 125,000 / ( 1 + 0.1132)⁴ = 0

0 = 0

Therefore, IRR is 11.32%

5)

Future value of first cash flow = 70000 / ( 1 + 0.1858)³ = 116,716.5328

Future value of 2nd cash flow = 100,000/ ( 1 + 0.1858)² = 140,612.64

Future value of 3rd cash flow = 0

Future value of 4th cash flow = 125,000 / ( 1 + 0.1858)⁰ = 125,000

Total future value = 125,000 + 140,612.64 + 116,716.5328 = 382,329.1728

Fv = PV ( 1+ r)ⁿ

382,329.1728 = 225,000 ( 1 + r )⁴

1.699241 = ( 1 + r )⁴

4th root of 1.699241 is 1.141731

1.141731 = 1 + r

0.141731 = r

MIRR is 14.17%