In: Finance
a) Baxter International has an equity beta of 0.8, a risk-free rate of 3% and a market portfoli return of 11%. The firm has a debt-to-equity ratio of 0.5 with the cost of debt at 6%. The marginal tax rate is 40%. What is the cost of capital of the firm, if CAPM holds?
b) Suppose the firm is also considering a warehouse renovation costing $60 million that is expected to generate cost savings of $12 million per year for six years. Should the firm undertake this project?
c) We know the discount rate for the firm is 7.48%. What would the NPV of the project be?
A) Cost of Equity
ERi = Rf+βi(ERm−Rf) = 3+0.8(11) = 11.8%
ERi = expected return of investment = 11.8%
Rf=risk-free rate = 3
βi=beta of the investment = 0.8
(ERm−Rf)=market risk premium = 11
Cost of Debt = 6% provided in Solution.
Finally, we’re ready to calculate weighted average cost of capital (WACC) = (E/V x Re) + ((D/V x Rd) x (1 – T))
The WACC is 7.70%, with the calculation being 50% * 11.8% + 50% * 6.0% * (1 - 40%).
B/C) Discount rate is 7.48% to get NPV for 6 years with a project investment of $60m
Year | Savings | |
1 | 12,000,000.00 | |
2 | 12,000,000.00 | |
3 | 12,000,000.00 | |
4 | 12,000,000.00 | |
5 | 12,000,000.00 | |
6 | 12,000,000.00 | |
NPV with 3% Risk free rate | 57,989,521.23 | SUM(B2:B7)/(1+7.48%)^3 |
60,000,000.00 | ||
(2,010,478.77) | ||
we cannot consider this project because we are making profit of -$2,010,478.77 ($60,000,000 - $57,989,521.23) considering 7.48% discount rate.