Question

You have been assigned analysis of a project that has a total of $500,000 in Net Investment. You have decided that you will start by issuing shares of common stock at a price of $60 per share. The shares will carry a beta of 1.2. The current risk-free rate is 3%, and the expected return on the market is 12%.

For the remainder, you plan to either borrow it via a bank loan or via the coupon bond market. The bank loan would carry an interest rate of 5%, while the coupon bonds would carry a rate of 8%. However, you can only borrow $200,000 of bank debt, while you could borrow $400,000 of coupon bonds. The tax rate is 21%

a. Which option is the better of the two below... show by calculating the respective WACC: (15 pts)
Option A: $200,000 of Bank Debt; $300,000 of common stock: WACC = _________

Option B: $400,000 of Coupon Bond Debt; $100,000 of common stock: WACC = _________

b. The project has expected NCFs of $50,000 during each of the 20 years of life. Given this, and using the better of the two financing options from (a), what is the NPV of the project?

Answer 1

Part (a):

Cost of equity (Re) as per CAPM= 13.80% as follows:

Given, cost of bank loan (Rl)= 5%, Cost of bond (Rb)= 8% and tax rate (T)= 21%

WACC= We*Re + Wd*Rd*(1-T)

Where We= Weight of equity, Re= Cost of equity, Wd= Weight of debt, Rd= Cost of debt and T= tax rate

Option A: Debt as bank loan

We = $300,000/$500,000 = 0.6

Wd= $200,000/$500,000 = 0.4

WACC= 0.6*0.1380 + 0.4*0.05*(1-0.21)= 9.86%

Option B: Debt as bond

We = $100,000/$500,000 = 0.2

Wd= $400,000/$500,000 = 0.8

WACC= 0.2*0.1380 + 0.8*0.08*(1-0.21)= 7.816%

Option B is better with lower WACC of 7.816%.

Part (b):

With NCF of $50,000 for 20 years, PV of cash flows= $497,702.68 as follows:

NPV of the project= PV of cash flows- Initial investment= $497,702.68- $500,000 = -$2,297.32