Question

Please show all work.

FINA Inc. considers a project with the following information:

Initial Outlay: 1,500

After-tax cash flows:

Year 1: -$100

Year 2: $1000

Year 3: $700

FINA’s assets are $500 million, financed through bank loans, bonds, preferred stocks, and common stocks. The amounts are as follows: Bank loans: $ 100 million borrowed at 10% Bonds: $180 million, paying 9% coupon with quarterly payments, and maturity of 5 years. FINA sold its $1,000 par-value bonds for $1,070 and had to incur $20 flotation cost per bond. Preferred Stocks: $20 million, paying $15 dividends per share. FINA sold its preferred shares for $210 and had to incur a $10/share flotation cost. Common Stocks: $200 million, the beta of FINA stocks is 1.5, the 90 day Treasury yield is 5%, and the return on the market portfolio is 15 %. FINA is subject to a 20% tax rate. Assuming the company uses WACC to compute the present value of the future cash flows, please find the following:

5) What is the WACC?

6) What is the IRR?

7) What is the Payback Period?

8) What is the NPV?

9) Should FINA accept the project? According to IRR? According to the Payback period? According to NPV?

Answer 1

Solution:

a)

Lets compute the WACC.

1. Cost of Bank Loan = 10%

2. Cost of Bonds

Face Value of bond   1000
Selling Price   1070
Flotation Cost   20
Coupon    9% quarterly ..... Coupon per quarter = $22.5 ... 1000*9%/4
Maturity   5years .......... 5*4 = 20 payments

Due to floatation cost, the amount actually raised by the company per bond is 1070-20 = $1050

I am calculating the bond yield using excel RATE function

=RATE(20,-22.5,1050,-1000)*4 = 7.78%

3. Cost of preference stock

Dividend per share   15
Selling Price   210
Flotation Cost   10
Actual money raised by the company = 210-10 = 200

Cost of preference stock = 15/200 = 7.5%

4. Cost of Equity

Beta   1.5
Risk Free rate, rf   5%
Return on Market Portfolio, Rm   15%
Cost of Equity = rf + beta *( Rm-rf) = 5% + 1.5 *(15% - 5%) = 20.0%

WACC Computations are as under:

WACC = 12.14%

b)

The computations for NPV, IRR and Payback period are as under:

IRR is 2.62%, which is less than WACC of 12.14% hence REJECT the project.

NPV is negative, hence REJECT the project

Payback is 2.86. It has to be compared with the internal hurdle payback rate of the company. Looks very high if the assets can be used for only 3 years.

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