Question

INTRUCTIONS: Answer all 4 questions. Assignment should be submitted in Blackboard by the due date. This is a 25 point assignment – six (6) points for each correct answer and 1 point for answering all 4 questions. Partial credit will be given if you give the wrong answer but show the correct formula. A firm has the following capital structure: 1. Bonds with market value of $3,000,000 2. Preferred Stock with a market value of $2,000,000 3. Common stock, of which 400,000 shares is outstanding. Presently, each common stock is selling at $30 per share The preferred stock price per share is $60 and pays a $5 dividend. Common stock shares sell for $30 and pay a $2 dividend. Dividends for common stock are expected to grow by 3%. Bond price is $950, and the bond coupon rate is 6.5%. The bonds mature in 7 years. The firm’s tax rate is 38%. The company has $3,500,000 in sales, and expenses of $1,200,000. The initial investment of $5,500,000 will be depreciated straight-line over 10 years. The project is expected to last 10 years.

1. What is the firm’s Weighted Average Cost of Capital (WACC)?

2. What is the firm’s Operating Cash Flow (OCF)?

3. Using the WACC is the NPV, using the WACC (use the answer from question 1 above), and OCF (use the answer from question 2 above)?

4. Based on your answer to question #3, would you accept or reject the project? Explain why?

Answer 1

Cost of equity = Dividend next year/ price today + growth rate of dividends

= $2*1.03/30+0.03= 0.09866 or 9.87%

market value of common stock = 400000 * $30 =$12 million

Cost of debt (r) is given by equating the present value of bond payoffs to the current price (it is the same as bond's YTM). Assuming annual coupon

950= 65/r*(1-1/(1+r)^7) + 1000/(1+r)^7

From SOLVER r= 0.074421 or 7.44%

Market value of Debt = $3 million

Cost of preferred stock = preferred dividend/ preferred stock price = $5/$60 = 12%

Market value of preferred stock = $2 million

So,

WACC = 12/(12+3+2)*9.87%+3/(12+3+2)*7.44%*(1-0.38)+2/(12+3+2)*12%

=0.091907 or 9.19%

Here,

Sales = $3.5 million

Less : Expenses = $1.2 million

Less : Depreciation = $5.5 million/10 = $550000

So, EBIT = $1750000

LEss: Interest = $3 million*7.44%= $223200

EBT = $1526800

Less: Taxes = $580184

So, OCF = EBIT + Depreciation - Taxes = $1750000 + 550000 - 580184 = $1719816

NPV = -5500000 + 1719816/0.0919* (1-1/1.0919^10)

=$5445481.96

As the NPV is positive , the firm should accept the project