Question

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:

1) What is the after-tax cost of the loans?

2) What is the after-tax cost of the bonds?

3) What is the after-tax cost of preferred stock?

4) What is the after-tax cost of common stock?

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?

10) FINA is expected to pay a $4 per share common stock dividend at the end of this year. The dividends are expected to grow at 6% per year forever. How much should be the value of FINA’s shares?

Answer 1

1) What is the after-tax cost of the loans?

after-tax cost = interest rate * (1 - tax rate) = 10% * (1 - 20%) = 8%

2) What is the after-tax cost of the bonds?

after-tax cost of bonds = YTM of bond * (1 - tax rate)

YTM is calculated using RATE function in Excel with these inputs :

nper = 5*4 (5 years to maturity with 4 quarterly coupon payments each year)

pmt = 1000 * 9% / 4 (quarterly coupon payment = face value * annual coupon rate / 4. This is a positive figure as it is an inflow to the bondholder)

pv = -1050 (net proceeds per bond = issue price - flotation cost = $1,070 - $20 = $1,050. This is a negative figure as it is an outflow to the buyer of the bond)

fv = 1000 (face value of the bond receivable on maturity. This is a positive figure as it is an inflow to the bondholder)

The RATE calculated is the quarterly YTM. To calculate the annual YTM, we multiply by 4.  

after-tax cost of bonds = YTM * (1 - tax rate)

after-tax cost of bonds = 6.235

3) What is the after-tax cost of preferred stock?

cost of preferred stock = (annual dividend / net proceeds per share)

net proceeds per share = price of share - flotation cost

net proceeds per share = $210 - $10 = $200

after-tax cost of preferred stock = 7.50%

4) What is the after-tax cost of common stock?

cost of equity = risk free rate + (beta * market risk premium)

cost of equity = 5% + (1.5 * (15% - 5%)) ==> 20%

5) What is the WACC?

WACC = (weight of loans * cost of loans) + (weight of debt * cost of debt) + (weight of preferred stock * cost of preferred stock) + (weight of common stock * cost of common stock)

WACC = 12.14%