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Empire Today Inc. has 10 million shares of common stock outstanding, 300,000 shares of 5% preferred...

Empire Today Inc. has 10 million shares of common stock outstanding, 300,000 shares of 5% preferred stock outstanding, and 7 million of 6.7 percent semiannual bonds outstanding, par value $1,000 each. The common stock currently sells for $85 per share and has a beta of 1.15, the preferred stock currently sells for $103 per share, and the bonds have 20 years to maturity and sell for 93% of par. The market risk premium is 11 percent, T-bills are yielding 2.14 %, and the firm's tax rate is 25.7%.

Calculate costs of Empire’s common stock, preferred stock, and debt, then explain your problem solving step-by-step.

Calculate the firm’s Weighted Average Cost of Capital and explain the meaning of WACC using your calculated solution. Show step by step

The CFO is assessing a potential project which will yield an IRR of 9.3%. The project has the firm level risk. Should the CFO accept the project?

Solutions

Expert Solution

Answer 1:

Using CAPM model:

Costs of Empire’s common stock = Risk free rate + Beta * Market risk premium

= 2.14% + 1.15 * 11%

= 14.79%

Costs of Empire’s common stock = 14.79%

Costs of preferred stock = Annual dividend / Current price = 100 * 5% / 103 = 4.854%

Costs of preferred stock = 4.854%

Cost of debt:

Bond face value = $1,000

Semiannual coupon = 1000 * 6.7% / 2= $33.50

Time to maturity = 20 years = 40 semiannual periods

Current price = 1000 * 93% = $930

Semiannual yield = RATE (nper, pmt, pv, fv, type) = RATE (40, 33.50, -930, 1000, 0) = 3.6874%

Cost of debt =3.6874% * 2 = 7.375%

Cost of debt = 7.375%

Answer 2:

To calculate WACC, first let us calculate market values of each of capital components.

WACC = Cost of equity * weight of equity + Cost of preferred stock * weight of preferred stock + Cost of debt * (1 - Tax rate) * weight of debt

= 14.79% * 850 / 7390.9 + 4.854% * 30.9 /7390.9 + 7.375% * (1 - 25.7%) * 6510 /7390.9

= 6.55%

WACC = 6.55%

As firm's capital consists of various components and each has different costs and tax treatment, it is essential to calculate weighted average cost of capital for it to be used to evaluate any investment proposition and decide whether to accept such proposition or not.

Answer 3:

Yes,

CFO should accept the project

As we calculated above WACC = 6.55%

The CFO is assessing a potential project which will yield an IRR of 9.3%.

Since IRR is higher than WACC, the potential project should be accepted.

jeff jeffy answered 1 year ago
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