Question

Company Y market value of debt is $6 million. Company Y has 300 000 shares outstanding and current share price is $22. The cost of equity is 15%. Company tax rate 35%.

a)What is the market value of equity?

b) What is the debt to equity ratio?

c)If company’s weighted average cost of capital (WACC) is 10%, what is the pretax cost of debt?

d) Company Y has an investment project, which cost $2 million and offers cash flow $1,5 million per year for next six years. Assume that the project has the same risk as the company’s core business. Calculate the NPV. Would you accept this project?

Answer 1

a

MV of equity = price*shares = 300000*22=6600000

b

D/E = 6/6.6=0.909

c

Weight of debt =D/(E+D) = 6/(6+6.6)=0.4761

Weight of equity=1-Weight of debt = = 1-0.4761=0.5239

Weight of Stock = 0.5239

Weight of Debt = 0.4761

Cost of Capital = Weight of Stock*Cost of Stock+Weight of Debt*Cost of Debt

10 = 15*0.5239+Cost of Debt*0.4761

Cost of Debt = 4.498

After tax rate = pre tax rate* (1-Tax rate)

4.498 = pre tax rate* (1-0.35)

pre tax rate= 6.92

d

Project A
Discount rate	0.1
Year	0	1	2	3	4	5	6
Cash flow stream	-2	1.5	1.5	1.5	1.5	1.5	1.5
Discounting factor	1	1.1	1.21	1.331	1.4641	1.61051	1.771561
Discounted cash flows project	-2	1.363636	1.239669	1.126972	1.0245202	0.931382	0.846711
NPV = Sum of discounted cash flows
NPV Project A =	4.53
Where
Discounting factor =	(1 + discount rate)^(Corresponding period in years)
Discounted Cashflow=	Cash flow stream/discounting factor
Accept project as NPV is positive