Question

Day Shades Inc. (DSI) has 20,000 bonds issued and outstanding with a 10 percent coupon rate compounded semi-annually. These bonds have 13 years left to maturity and they currently sell for 104 percent of par value.

The company has 5 million shares issued and outstanding with a market value of $3.85 per share. The company’s stock has a beta of 1.20. The expected return on the market is 11 percent and the yield on the risk-free asset is currently 6 percent.
Year 0 Years 1 Year 2 Year 3 Year4 Year 5 Capital Expenses Working Capital Revenue Operating Expenses EBITDA D&A EBIT ×(1 - t) Net Income D&A Cash Flow from Operations Working Capital

Free Cash Flows   
  

DSI is currently considering a new five-year expansion project that requires an initial investment of $3.8 million in fixed assets. At the end of the project, the fixed assets would be depreciated to zero over the project’s five year life. The fixed assets can be sold for $550,000. Additionally, DSI will need to make an initial investment of $300,000 in working capital for the project and an additional investment of $50,000 in every year thereafter. The project is expected to generate annual sales revenue of $2,945,000 with associated costs of $1,255,000. The annual tax rate for DSI is 36 percent.

A. Calculate the weighted average cost of capital (WACC) for DSI.

B. Using the projected after-tax cash flows for DSI, calculate and comment on the Net Present Value (NPV) of the project.

C. Under which circumstance can the WACC be used in investment appraisals

D. Why do we use an after tax figure for the cost of debt but not for the cost of equity?

Answer 1