Question

(For this part, you MUST present sufficient solution steps, and MUST apply specific Excel functions =NPV(…), =IRR(…), =AVERAGE(…), =YIELD(…)

Case Two (22 pts)

Given the following information for Bajor Co.:

Debt: Bajor’s long-term debt capital consists of bonds with 6.250 percent coupon rate (semiannual coupon payments), 9 years time-to-maturity, and current price of 106.61 percent of its par value (i.e., price = 106.61 relative to full amount redemption par of 100).

Preferred stock: Bajor has not issued any preferred stocks.

Common stock (equity):

• Bajor’s equity capital consists of common stocks with the most recent annual dividend of $0.92 per share, and a current stock price of $14 per share.  

• According to online data sources, Bajor’s long-term dividend growth (for next 5-Year average, per annum) g = 4.5% per year.

• The “risk-free” Treasury bill return is 3.8%; the market expected return for the stock market on average is 12.3%; and Bajor’s systematic risk (Beta) is 0.71.

Taxes: The applicable federal-plus-state corporate tax rate for Bajor is 25.7 percent.

Capital weight: Bajor’s “Market Cap” amounts to $18.23 billion, and “Total Debt” amounts to $14.44 billion. You can use such data to estimate the capital weights for equity and debt, respectively (We and Wd).

Time constraint: For any investment projects, Bajor are required by her investors to recover its initial cost within no more than 6 years.

Q1: What is Bajor’s pretax cost of debt Rd, cost of equity Re, and WACC, respectively? (Hint: For the best estimate of cost of equity Re, you must apply both CAPM and Dividend Growth Model and then average the two estimates.)

Q2: There are three investment projects available to Bajor:  

Project A costs $12 million to invest today, and then provides “cash inflow from assets” of $2.50 million per year for the next 7 years.

Project B costs $18 million to invest today, and then provides “cash inflow from assets” of $3.30 million per year for the next 8 years.

Project C costs $30 million to invest today, and then provides “cash inflow from assets” of $4.25 million per year for the next 10 years.

If Projects A, B & C are mutually exclusive, which project(s) should Bajor accept? (You must apply the three major investment evaluation rules NPV, IRR and Payback)

Q3: If Projects A, B & C are independent, which project(s) should Bajor accept? (You must apply the three major investment evaluation rules NPV, IRR and Payback)

Answer 1

1)
Cost of debt:
Face value	100
Coupon Rate (Semiannual) = 6.25%/2	3.13%
Coupon payment = PMT = 3.13% x 100	3.125
Current Price = PV	106.61
Period = 9 x 2	18
YTM = Rate (semiannual)	2.66%
Annual YTM = Pretax cost of Debt	5.32%
Cost of Equity
Cost of Equity ( Dividend Growth Model) = (D0 x ( 1 + g)/P0) + g
Cost of Equity = 0.92 x ( 1 + 4.5%)/$14 + 4.5%	11.37%
Cost of Equity (CAPM) = Rf + beta x (Rm-Rf)
Cost of Equity (CAPM) = 3.8% + 0.71 x (12.3% - 3.8%)	9.84%
Average Cost of Equity  (11.37% + 9.84%)/2	10.60%
WACC
	Market cap $ billions)	Weight
Equity	3.79	20.79%
Debt	14.44	79.21%
Total	18.23
WACC = We x Re + Wd x Rd x (1 - tax)
Wacc = 20.79% x 10.60% + 79.21% x 5.32% x (1-25.7%)	5.33%
2)
Q2: There are three investment projects available to Bajor:
	NPV (Amount in Milllion)	IRR	Payback period
Project A costs $12 million to invest today, and then provides “cash inflow from assets” of $2.50 million per year for the next 7 years.	$                            2.29	10.43%	4.80	Years
Project B costs $18 million to invest today, and then provides “cash inflow from assets” of $3.30 million per year for the next 8 years.	$                            3.04	9.39%	5.45	Years
Project C costs $30 million to invest today, and then provides “cash inflow from assets” of $4.25 million per year for the next 10 years.	$                            2.29	6.89%	7.06	Years
If Projects A, B & C are mutually exclusive, which project(s) should Bajor accept? (You must apply the three major investment evaluation rules NPV, IRR and Payback)
Project C would be rejected as it does not meet Time constraint of 6 years.
In case of mutually exclusive projects, the project with highest net present value or the highest IRR or the lowest payback period is preferred since Project A would be selected because its IRR is the highest and payback period is shortest but NPV is the lowest. Project B has the highest NPV but IRR is lesser than the Project A and payback period is more than project A.Both Project A and B could be consider.
3)
Independent is favorable if the net present value is positive and/or IRR is higher than the hurdle rate and/or the payback period is shorter than a specific reference period.Project A and B both are selected.