Question

1)Healthy Foods has 23,000 shares of common stock outstanding at a price per share of $60 and a rate of return of 14.2 percent. The firm has $300,000 of preferred stock outstanding at a rate of 8%. The outstanding debt has a total value of $357,000 and the yield-to-maturity on the debt is 7percent before tax. What is the firm's weighted average cost of capital if the tax rate is 40 percent? Show calculations

2)Bono Inc. is considering a project that costs $10 million but will produce cash inflows of $5.1 million for 3 years. Bono Inc. has a target equity ratio of 60% and a target debt ratio of 40%. The company’s cost of equity is 13% and the after tax cost of debt is 6%. What is the NPV of the project? Assume the project has average risk. Show calculations.   

Answer 1

Answer : 1) Calculation of Weighted Average cost of Capital :

Calculation of WACC of the Firm

WACC = (Cost of After tax Debt * Weight of Debt) + ( Cost of Equity * Weight of Equity) + (Cost of Preferred Stock * Weight of Preferred Stock)

Calculation of Weights of Debt , Equity and Preferred Stock

Value of Debt = 357,000

Market Value of Equity = Number of Equity shares * Price per share

= 23,000 * 60

= 1,380,000

Market Value of Preferred Stock = 300,000

Total Value = Value of Debt + Market Value of Equity + Value of Preferred Stock

= 357,000 + 1,380,000 + 300,000

= 2,037,000

Weight of Debt = Value of Debt / Total Market Value

= 357000 / 2037000

= 0.17525773195 or 0.1752

Weight of Preferred Stock = Value of Preferred Stock / Total Market Value

= 300000 / 2037000

= 0.147275405 or 0.1473

Weight of Equity = Market Value of Equity / Total Market Value

= 1,380,000 / 2037000

= 0.67746686303 or 0.6775

WACC = [7% * (1 - 0.40) * 0.17525773195] + [ 14.2% * 0.67746686303] + [8% * 0.147275405]

= 0.7361% + 9.62% + 1.1782%

= 11.5343% or 11.53%

Answer : 2 ) Calculation of Net Present Value

Net Present Value = Present Value of Cash Inflow - Present value of Cash Outflow

For the purpose of calculation of Present value we need to calculate WACC

WACC = (Cost of After tax Debt * Weight of Debt) + ( Cost of Equity * Weight of Equity)

= (6% * 0.40) + (13% * 0.60)

= 10.20%

Net Present Value = (Annual Cash Inflow * PVAF @ 10.20% for 3 years) - 10,000,000

= (5,100,000 * 2.47812179169) - 10,000,000

= 12,638,421.1376 - 10,000,000

= 2,638,421.1376