Question

XYZ Corporation has 200 shares of common stock outstanding at a market price of £37 a share. Suppose the firm common stock has a beta of 1.37, the risk free rate is 3.4 per cent, and the market risk premium is 8.2 per cent. The firm also has 5 bonds outstanding with a face value of £1,000 per bond that are selling at 99 per cent of par. The bonds have a coupon rate of 6 per cent and a yield to maturity of 6.7 per cent. All interest is tax deductible. If the tax rate is 21 per cent, what is the weighted average cost of capital?

The firm is considering a project that has the same risk level as
the firm's current operations, an initial cost of £135,000 and cash inflows of £52,000, £100,000, and £50,000 for Years 1 to 3, respectively. What is the net present value (NPV) of the project? Explain whether would you invest in this project? Show the calculations.

Answer 1

The WACC is computed as shown below:

= cost of debt (1 - tax rate) x weight of debt + cost of equity x weight of equity

cost of equity is computed as follows:

= risk free rate + beta x market risk premium

= 0.034 + 1.37 x 0.082

= 14.634%

So, the WACC will be computed as follows:

= 0.067 x (1 - 0.21) x [ ( 1,000 x 5 x 99%) / ( 1,000 x 5 x 99% + 200 shares x 37) ] + 0.14634 x [ (200 shares x 37) / (1,000 x 5 x 99% + 200 shares x 37) ]

= 0.05293 x ( 4,950 / 12,350) + 0.14634 x ( 7,400 / 12,350)

= 10.89% Approximately

The NPV is computed as shown below:

= Initial investment + Present value of future cash flows

Present value is computed as follows:

= Future value / (1 + r)ⁿ

So, the NPV is computed as follows:

= - 135,000 + 52,000 / 1.14634 + 100,000 / 1.14634² + 50,000 / 1.14634³

= 19,651.45 Approximately

Since the NPV of the investment is positive, hence the firm shall make the investment in the project.

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