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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