Question

In: Accounting

A publicly‐held corporation has a total debt of $12 million with an average interest cost of...

  1. A publicly‐held corporation has a total debt of $12 million with an average interest cost of 15%. The company has outstanding 1 million shares of common stock, currently traded at a price of ₺10/share in NYSE. The company is subject to a 20% corporate tax rate.
    1. If the risk‐free rate of interest (current yield on short‐term T‐bills) is 8%, the stock market is expected to return 18% next year and the company’s estimated (CAPM) beta is 1.5, what is the required rate of return on its equity?
    2. Calculate the company’s weighted average cost of capital.

The firm in above is considering a new project, which requires an initial investment in equipment of 90,000 and also an initial investment in working capital of 10,000 (at t = 0). You expect the project to produce sales revenue of 120,000 per year for three years. You estimate manufacturing costs at 60% of revenues. (Assume all revenues and costs occur at year‐end) The equipment fully depreciates using straight‐line depreciation over three years. At the end of the project, the firm can sell the equipment for 10,000 and also recover the investment in net working capital. a. Find the project’s payback period, IRR, NPV and profitability index. b. Should the company invest in the project? Explain. c. Does your decision in (b) depend on the way the project is financed? If so, how?

PS:I wrote the first question because the second question will be solved using the data from the first quesion. Sorry for posting 2 questions.

Solutions

Expert Solution

Solution

The company has a Debt of $12 Million. Pre-tax Cost of Debt being 15%. Rate of Tax is 20%.
Therefore, Post-Tax Cost of Debt (kd) = 15% x (1 - 0.2)
= 15% x 0.8
= 12%

Now, Company has 1 Million outstanding common stock currently being traded at $10 per share.
Therefore, Value of Common Stock outstanding = $10 Million

Again, we have been given that Risk-free rate (Rf) is 8%, Market Return (Rm) being 18%, and CAPM Beta (B) is 1.50.
Therefore, Required rate of return on equity, or Cost of Equity (ke) = Rf + [(Rm - Rf) x B]
= 8% + [(18% - 8%) x 1.50]
= 8% + 15%
= 23%

Now as we have the required information, we can calculate the Weighted Average Cost of Capital (WACC) as follows,

Particulars Value ($ in Millions) Weight Cost Weighted Cost
Common Stock 10 0.455 23% 10.465
Debt 12 0.545 12% 6.540
TOTAL 22 1.000 17.005

Therefore, the Weighted Average Cost of Capital (WACC) will be 17.005%.

Now let us move to the next part.

Initial Investment = $90000
Initial Working Capital Requirement (will be recovered at the end) = $10000
Therefore, Total Initial Outlay = $100000

Again,
Revenue per year = $120000
Manufacturing Cost (60% of Revenue) = $72000
Net revenue per year = $48000

Depreciation per year = (Initial Investment - Scrap Value) / Number of years
= (90000 - 10000) / 3
= 26666.67 (Approx.)

Terminal Value = Recovery of Working Capital + Scrap Value
= $(10000 + 10000)
= $20000

Therefore,
Initial Outflow = $100000
Annual Cash Flow After Tax (CFAT) = [(Net Revenue - Depreciation) x (1 - Tax Rate)] + Depreciation
= [(48000 - 26666.67) x (1 - 0.2)] + 26666.67
= 17066.67 + 26666.67
= $43733.34
Terminal Value = $20000
Therefore, Cash Flow at 3rd Year will be ($43733.34 + $20000) = $63733.34

Now,
We will making our calculations as follows,
Project PBP:
We need to require the following table,

Year Cash Flows Cumulative Cash Flows
1 $ 43,733.34 $       43,733.34
2 $ 43,733.34 $       87,466.68
3 $ 63,733.34 $    151,200.02

At PBP, we know that the Investor will be able to recover its Initial Outlay. Here, the Initial Outlay is $100000, which will be recovered somewhere in between 2 to 3 years. The exact value can be determined using interpolation as follows,

(PBP - 2) / (3 - 2) = (100000 - 87466.68) / (151200 - 87466.68)
Or, PBP - 2 = 12533.32 / 63733.32
Or, PBP = 2.197 (Approx.)

Therefore Project PBP will be 2.197 Years

Project IRR:
The calculation will be made using Trial-and-Error method. For our calculation we are using 22% and 23%. The calculation is as follows,

Year Cash Flows PVIF @ 22% Discounted Cash Flow PVIF @ 23% Discounted Cash Flow
0 $ (100,000.00) 1.0000 $   (100,000.00) 1.0000 $    (100,000.00)
1 $      43,733.34 0.8197 $        35,847.00 0.8130 $         35,555.56
2 $      43,733.34 0.6719 $        29,382.79 0.6610 $         28,906.96
3 $      63,733.34 0.5507 $        35,098.39 0.5374 $         34,249.27
$              328.18 $         (1,288.21)

At IRR, Intial Outflow will be equal to Discounted Cash Flows. Therefore, it is clear from above that IRR will be somewhere in between 22% and 23%. The exact value will be calculated using interpolation as follows,

(IRR - 22) / (23 - 22) = (0 - 328.18) / (- 1288.21 - 328.18)
Or, IRR - 22 = 328.18 / 1616.39
Or, IRR = 22.203 (Approx.)

Therefore, Project IRR will be 22.203%.

Project NPV (Using Discounting rate (WACC) = 17.005%):

Year Cash Flows PVIF @ 17.005% Discounted Cash Flow
0 $ (100,000.00) 1.0000 $   (100,000.00)
1 $      43,733.34 0.8547 $        37,377.33
2 $      43,733.34 0.7305 $        31,945.07
3 $      63,733.34 0.6243 $        39,788.12
NET PRESENT VALUE $          9,110.51

Therefore, Net Present Value will be $9110.51.

Profitability Index:

Profitablity Index = PV of Future Cash Flows / Initial Outflow
= (43733.34 + 43733.34 + 63733.34) / 100000
= 1.512 (Approx.)

From the calculated results, it can be concluded that as the NPV is positive, and the IRR is also more than the Required Rate of Return, the project should be accepted.

It is true that the investment decision depends upon the level of financing. As given, the investment is financed by 15% Debt and Common Stock. The ratio of weights between the mode of financing is 0.455 : 0.545. If the financing modes are altered, for example reducing the Debt quantum, or Increase in Common Stock will definitely affect the WACC, resulting to which the NPV calculation will be affected. Therefore, we can say that investment decision depends upon the level of financing.


Related Solutions

The Valley Corporation has $500,000 of debt outstanding, and itpays an interest rate of 12%...
The Valley Corporation has $500,000 of debt outstanding, and it pays an interest rate of 12% annually. Valley's annual sales are $3 million, its average tax rate is 35%, and its net profit margin on sales is 6%. What is Valley's TIE ratio?
​(Weighted average cost of capital​) Crawford Enterprises is a publicly held company located in​ Arnold, Kansas....
​(Weighted average cost of capital​) Crawford Enterprises is a publicly held company located in​ Arnold, Kansas. The firm began as a small tool and die shop but grew over its​ 35-year life to become a leading supplier of metal fabrication equipment used in the farm tractor industry. At the close of​ 2015, the​ firm's balance sheet appeared as​ follows:. .At present the​ firm's common stock is selling for a price equal to its book​ value, and the​ firm's bonds are...
​(Weighted average cost of capital​) Crawford Enterprises is a publicly held company located in​ Arnold, Kansas....
​(Weighted average cost of capital​) Crawford Enterprises is a publicly held company located in​ Arnold, Kansas. The firm began as a small tool and die shop but grew over its​ 35-year life to become a leading supplier of metal fabrication equipment used in the farm tractor industry. At the close of​ 2015, the​firm's balance sheet appeared as​ follows: Cash: 450,000 Accounts receivable: 4,250,000 Inventories: 8,400,000 Net property, plant, and equipment: 17,821,000 Total assets: 30,921,000 Long-term debt: 11,800,000 Common equity: 19,121,000...
A company has $400 million worth of debt outstanding with an average interest rate of 5%...
A company has $400 million worth of debt outstanding with an average interest rate of 5% and 50 million common shares outstanding worth $12 each. The company’s tax rate is 34%, beta is 1.2, the yield on 10-year Treasury notes is 1.5% and the expected market return is 9.5%. What is the company’s weighted average cost of capital (WACC) based on the current weights for debt and common stock in its capital structure?
Question 1 A company has $400 million worth of debt outstanding with an average interest rate...
Question 1 A company has $400 million worth of debt outstanding with an average interest rate of 5% and 50 million common shares outstanding worth $12 each. The company’s tax rate is 28%, beta is 1.3, the yield on 10-year Treasury notes is 1.5% and the expected market return is 9.5%. What is the company’s weighted average cost of capital (WACC) based on the current weights for debt and common stock in its capital structure? a. 7.98% b. 8.10% c....
Lambda Ltd has $100 million of perpetual debt outstanding with an interest cost of 9%. The...
Lambda Ltd has $100 million of perpetual debt outstanding with an interest cost of 9%. The company is currently subject to a corporate tax rate of 30%. Following national elections, the incoming government unexpectedly passes a law that lowers the corporate tax rate for all companies to 25%. According to Modigliani and Miller what will be the most likely immediate change in the market value of the company?
Marlo, a publicly held corporation with a 21 percent tax rate, has agreed to pay an...
Marlo, a publicly held corporation with a 21 percent tax rate, has agreed to pay an annual salary of $1.32 million to its employee, Mrs. Ryman. In making your calculation, ignore the employer payroll tax. Compute Marlo’s after-tax cost of the salary when Mrs. Ryman is Marlo's principal executive officer (PEO). Compute Marlo’s after-tax cost of the salary when Mrs. Ryman is Marlo's Director of Marketing and the sixth most highly compensated employee in the company.
x is a publicly held corporation with a subsidiary, S, of which X always has owned...
x is a publicly held corporation with a subsidiary, S, of which X always has owned 100 percent of the outstanding stock. what is the total tax liability for X and S under each of the following sets of facts? in this problem, use all corporate tax rate brackets. a) X has taxable income of $2.2 million and S has no income. b) X has taxable income of $2 million and S has taxable income of $200,000 c) same as...
a firm has total debt of $900 an total equity of $1600. the cost of debt...
a firm has total debt of $900 an total equity of $1600. the cost of debt is 10% and the unlevered rate of return is 13%. The tax rate is 34%. What is the cost equity? A) 14.69% B)14.11% C) 13.88% D)12.29% E) 12.69%
Quantity Total Cost Total Fixed Cost Total Variable Cost Average Fixed Cost Average Total Cost Average...
Quantity Total Cost Total Fixed Cost Total Variable Cost Average Fixed Cost Average Total Cost Average Variable Cost Marginal Cost 0 30 1 75 2 150 3 255 4 380 5 525 6 680 7 840 8 1010 9 1200 Given the quantity and total cost, calculate for total fixed cost, total variable cost, average fixed cost, average total cost, average variable cost, and marginal cost. Excel formulas would be nice but not required.
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT