Question

Suppose you have been hired as a financial consultant to DE Ltd, a large, publicly traded firm that is the market share leader in radar detection systems (RDSs). DEI’s tax rate is 34 per cent. You have the following market data on DEI’s securities: Debt: 46,600 6.9 per cent coupon bonds outstanding, 21 years to maturity, selling for 93.4 per cent of par; the bonds have a $1000 par value each and make semi-annual payments. Common stock: 766,000 shares outstanding, selling for $95.60 per share; the beta is 1.13. Preferred stock: 36,600 shares paying a fixed dividend of $6.25 per preference share, selling for $93.60 per share. Market: 7.05 per cent expected market risk premium; 5.25 per cent risk-free rate. Requirement 1- Calculate the firm’s before tax and after-tax cost of debt, cost of preferred shares and the cost of ordinary shares. Requirement 2- Calculate the firm’s weighted average cost of capital (use the market values when calculating the weights). Requirement 3- The company is looking at setting up a manufacturing plant overseas to produce a new line of RDSs. The new project would cost $1.7 million and is expected to provide $200,000 of cashflow at the end of each year forever. The project is, however, somewhat riskier than a typical project for DEI, primarily because the plant is being located overseas. Management has told you to use an adjustment factor of +3 per cent to account for this increased riskiness. a) What is the appropriate discount rate to use when evaluating DEI’s project? b. Use this discount rate (that you calculated in part a) to estimate the net present value of the project. Should the firm accept the project? c. Discuss whether your decision would have been different if you have used the company’s overall WACC (unadjusted for project’s higher risk) when discounting the projects cashflows in your NPV calculation.

Answer 1

Requirement-1

Before-tax & after-tax csot of Debt

After-tax cost of bonds, kd

using the formula to find the present value,ie.current market Price of bonds,

Price/PV =PV of its future cash flows=PV of all its future coupon cash flows+PV of face value to be received at maturity----both discounted at the Yield or YTM--which is the before-tax cost of the bond

ie. Price /PV =(Pmt.*(1-(1+r)^-n)/r)+(FV/(1+r)^n)

where, price is given as 1000*93.4%= $ 934

Pmt.= The semi-annual   coupon in $ , ie. 1000*6.9%/2= $ 34.5

r= the   semi-annual Yield or YTM /before-tax semi-annual cost of the bond--- to be found out---??

n= no.of coupon period still to maturity, ie. 21 yrs.*2= 42

FV= face value, ie. $ 1000

So, plugging in these values in the formula,

ie.934=(34.5*(1-(1+r)^-42)/r)+(1000/(1+r)^42)

Solving the above for r, we get the before-tax semi-annual cost of the bond as

3.76526%

So, the annual before-tax cost=

(1+3.76526%)^2-1=

7.67229%

now the after-tax annual cost of the bond, kd==

Before tax cost*(1-Tax rate)

ie. 7.67229%*(1-34%)=

5.06%

Cost of preferred stock, kps

k ps= $ dividend/Current market price

ie. 6.25/93.60=

6.68%

Cost of common stock, ke

as per CAPM,ke=RFR+(Beta*Market risk premium)

ie. 5.25%+(1.13*7.05%)=

13.22%

Requirement--2
WACC wkgs.
Type of capital	Market Values		Wt. to Total	Cost	Wt.*Cost
Bonds	46600*934=	43524400	36.21%	5.06%	1.83%
Common stock	766000*95.60=	73229600	60.93%	13.22%	8.06%
Pref. stock	36600*93.70=	3429420	2.85%	6.68%	0.19%
Total		1.2E+08	100.00%	WACC=	10.08%
				AdjFactor	3%
				Adj. WACC=	13.08%

Requirement-3

Appropriate discount rate = 13.08%

NPV of the project= -1700000+(200000/13.08%)=

-170948.01

Should the firm accept the project? ---NO

NPV is NEGATIVE , hence will not add value to DEI

c. NPV at the unadjusted WACC

NPV of the project= -1700000+(200000/10.08%)=

284126.98

YES. The firm can accept the project , as NPV is POSITIVE, when CFs are discounted at the unadjusted WACC, 10.08%