Question

First and Ten Corporation’s stock returns have a covariance with the market portfolio of .0493. The standard deviation of the returns on the market portfolio is 22 percent and the expected market risk premium is 6.8 percent. The company has bonds outstanding with a total market value of $55.5 million and a yield to maturity of 5.7 percent. The company also has 4.7 million shares of common stock outstanding, each selling for $46. The company’s CEO considers the firm’s current debt-equity ratio optimal. The corporate tax rate is 25 percent and Treasury bills currently yield 3.1 percent. The company is considering the purchase of additional equipment that would cost $51.5 million. The expected unlevered cash flows from the equipment are $17.15 million per year for 5 years. Purchasing the equipment will not change the risk level of the firm.

  

Calculate the NPV of the project. (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89)

Answer 1

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

market value of debt = $55,500,000

market value of common stock = shares outstanding * market price per share

market value of common stock = 4,700,000 * $75 = $216,200,000

total market value = $55,500,000 + $216,200,000 = $271,700,000

weight of debt = market value of debt / total market value

weight of debt = $55,500,000 / $271,700,000 = 0.2043

weight of common stock = market value of common stock / total market value

weight of common stock = $216,200,000 / $271,700,000 = 0.7957

cost of debt = YTM * (1 - tax rate) = 5.7% * (1 - 25%) = 4.28%

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

beta = covariance of stock with market / variance of market

variance of market = standard deviation2

beta = 0.0493 / 0.222

beta = 1.0186

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

cost of common stock = 3.1% + (1.0186 * 6.8%)

cost of common stock = 10.03%

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

WACC = (0.2043 * 4.28%) + (0.7957 * 10.03%)

WACC = 8.851602%

NPV is calculated using NPV function in Excel

NPV is $15,645,166.88