Question
In: Accounting
You have the following information about Burgundy Basins, a sink manufacturer. Equity shares outstanding 20 million...
You have the following information about Burgundy Basins, a sink manufacturer.
| Equity shares outstanding | 20 | million | |
| Stock price per share | $ | 30 | |
| Yield to maturity on debt | 7.5 | % | |
| Book value of interest-bearing debt | $ | 320 | million |
| Coupon interest rate on debt | 3.5 | % | |
| Market value of debt | $ | 200 | million |
| Book value of equity | $ | 320 | million |
| Cost of equity capital | 10.0 | % | |
| Tax rate | 35 | % | |
Burgundy is contemplating what for the company is an average-risk investment costing $20 million and promising an annual ATCF of $4.0 million in perpetuity.
a. What is the internal rate of return on the investment? (Round your answer to 2 decimal places.)
b. What is Burgundy's weighted-average cost of capital? (Round your answer to 2 decimal places.)
Solutions
Expert Solution
Answer :
(a). Computation of internal rate of return
Internal rate of rate at which net present value (NPV) is zero
Present value of perpetuity is simply C/r,where in C is the same cash flow every year and r is the discount rate.
If we equate this present value to the initial investment, then the NPV becomes zero, and thus the r comes to be known as IRR
Thus, simply, IRR = C / initial investment
IRR = 0.4/20
IRR = 2%
(b). Computation of weighted average cost of capital ('(WACC')
The WACC can be computed by taking book value of weight or market value of weight
Computation of WACC by taking market value of weight
| Capital | Amount $ | Rates | Tax impact | Rates After tax | Weight | WACC |
| Market value of equity shares | 600 | 10 | 10 | 0.75 | 7.50 | |
| Market value of interest bearing debt | 200 | 7.5 | 2.625 | 4.875 | 0.25 | 1.22 |
| Total | 800 | 0 | 8.72 | |||
| Computation of WACC by taking book value of weight | ||||||
| Capital | Amount $ | Rates | Tax impact | Rate after tax | Weight | WACC |
| Book value of equity shares | 320 | 10 | 0 | 10 | 0.5 | 5.00 |
| Book value of interest bearing debt | 320 | 7.5 | 2.625 | 4.875 | 0.5 | 2.44 |
| 640 | 1 | 7.44 | ||||
| Market value of equity shares | |
| No of equity shares (in million) | 20 |
| Market value of shares ($) | 30 |
| Market value of equity share capital | 600 |
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