Question

Road Runner Corporation is considering an expansion of its manufacturing plant.  The project would cost $30 million in initial investment but it’s expected to result in after tax cash flows to the firm of $3.5 million per year for the next 14 years.  You have the following information about the firm’s capital structure and market conditions:  

Common stock:           2 million shares outstanding

                                    Current market price is $35 per share

                                    Par value is $1 per share

                                    Beta = 1.2

Bonds:                         90,000 bonds outstanding

                                    8% coupon paid semi-annually

                                    8 years to maturity

                                    Selling at 112% of face value

Market conditions       The average market return is 12%

                                    Risk free rate is 4%

                                    Tax rate is 32%

1. What is the firm’s weighted average cost of capital?  
2. Using NPV principles, should the firm proceed with this expansion?

Answer 1

a. What is the firm’s weighted average cost of capital? 12.41%

1. Please note that the Par/Face Value of the Bond is not provided in the question. The same is assumed as $100.

2. WACC is calculated basis the market value of equity and debt and not basis the book value. Since the motive of the company is to increase shareholders value, calculating WACC basis market value is more appropriate.

b. Using NPV principles, should the firm proceed with this expansion?

NPV = -$7,278,676

Since the NPV is negative, the firm should not proceed with this expansion.

Workings: