Question

In: Finance

a) Baxter International has an equity beta of 0.8, a risk-free rate of 3% and a...

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?

Solutions

Expert Solution

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.


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