Question

The director for S Corp. manufacturers of playground equipment, is considering a plan to expand production facilities in order to meet an increase in demand. He estimates that this expansion will produce a rate of return of 11%. The firm’s target capital structure calls for a debt/equity ratio of .8 . S Corp has a bond issue outstanding for that will mature in 25 years and has a 7% annual coupon rate. The bonds are currently selling for $804. The firm has maintained a constant growth rate of 6%. S Corp’s next expected dividend is $2(D1) and it current stock price is $40. Its tax rate is 21%. Should it undertake the expansion? Calculate the Cost of bonds. Calculate the Cost of equity. Calculate the WACC

Answer 1

D/A = D/(E+D)

D/A = 0.8/(1+0.8)

=0.4444

Weight of equity = 1-D/A

Weight of equity = 1-0.4444

W(E)=0.5556

Weight of debt = D/A

Weight of debt = 0.4444

W(D)=0.4444

Cost of equity

As per DDM

Price = Dividend in 1 year/(cost of equity - growth rate)

40 = 2/ (Cost of equity - 0.06)

Cost of equity% = 11

Cost of debt

K = N

Bond Price =∑ [(Annual Coupon)/(1 + YTM)^k]     +   Par value/(1 + YTM)^N

k=1

K =25

804 =∑ [(7*1000/100)/(1 + YTM/100)^k]     +   1000/(1 + YTM/100)^25

k=1

YTM = 9

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 9*(1-0.21)

= 7.11

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=7.11*0.4444+11*0.5556

WACC =9.27%

Undertake expansion as WACC is less than return