Question

Case Narrative:

The firm’s tax rate is 35%. The company has $2,000,000 in annual sales, and annual fixed expenses of $1,100,000 and $500,000 in variable expenses. There was an initial investment in the firm of $1,500,000, which will be depreciated straight-line over 10 years. The project is expected to last 10 years.

The firm has a Capital Structure as follows:

The market value of the bonds is $2,000,000.

The market value of the Preferred Stock is $1,000,000.

The market value of the Common stock is $7,000,000

The cost of the preferred stock is 4%, the cost of the common stock is 6%, the cost of the bonds is 8%.

What is the firm’s WACC? __________________________________Chapter 13

What is the firm’s OCF ______________________________________Chapter 9

What is the NPV, __________________­­­­­­­­­­­­­­­_________________________Chapter 8

Based on your answer to question #3, will to accept or reject this project? What is the reasoning for accepting or rejecting the project?

Answer 1

1) WACC

After tax cost of debt = 8% x (1 - 0.35) = 5.20%

Total market value of firm = market value of bonds + market value of preferred stock + market value of common stock = $2,000,000 + $1,000,000 + $7,000,000 = $10,000,000

Weight of debt = $2,000,000 / $10,000,000 = 0.20

Weight of preferred stock = $1,000,000 / $10,000,000 = 0.10

Weight of common stock = $7,000,000 / $10,000,000 = 0.70

WACC = After tax cost of debt x weight of debt + cost of preferred stock x weight of preferred stock + cost of common stock x weight of common stock = 5.20% x 0.20 + 4% x 0.10 + 6% x 0.70 = 5.64%

2) OCF

OCF

Sales	$2,000,000
Less: Variable cost	$500,000
Less: Fixed costs (other than depreciation)	$1,100,000
Less: Depreciation [ $1,500,000 / 10 ]	$150,000
Earnings before tax	$250,000
Less: Tax@35%	$87,500
Net Income	$162,500
Add: Depreciation	$150,000
Operating cash flow (OCF)	$312,500

3) NPV

we will discount the OCF using WACC as the discount rate.

NPV = (-)Initial investment + Annual OCF x PVIFA (5.64%, 10) = (-)$1,500,000 + $312,500 x 7.48726536264 = $839,770.42582 or $839,770.43

Since NPV is postive, the project should be accepted.

NOTE: PVIFA = Present value interest factor annuity of $1 and is computed as follows -

where, r is the interest rate or WACC in our case and n is no. of years

Let me know in case of any issues in the comments.