Question

A firm is considering investing in a new project. According to its cost of capital while using debt, preferred stock and new common stock, the project is expected to have an initial after tax cost of $5,000,000. Furthermore, the project is expected to provide after-tax operating cash flows of $1,800,000 in year 1, $2,900,000 in year 2, $2,700,000 in year 3 and $2,300,000 in year 4.

A firm has determined its optimal capital structure, which is composed of the following sources and target market value proportions.

Source of Capital	Target Market Proportions
Long-term debt	40%
Preferred stock	10%
Common stock equity	50%

Debt: The firm can raise debt by selling 15-year, $1,000 par value, 9% coupon interest rate bonds that pay annual interest. A flotation cost of 4 percent of the face value would be required in addition to the premium of $10.

Preferred Stock: Preferred stock, regardless of the amount sold, can be issued with an $80 par value and a 12% annual dividend rate. The cost of issuing and selling the stock is $3 per share.

Common Stock: The firm’s common stock is currently selling for $10 per share. The dividend that was paid last year was $0.87. Its dividend payments have been growing at a constant rate of 5% per year. It is expected that to attract buyers, a new common stock issue must be underpriced $2 per share, and the firm must also pay $1 per share in flotation costs.

Retained Earnings: A corporation expects to have earnings available to common shareholders (net income) of $1,000,000 in the coming year. The firm plans to pay 40 percent of earnings available in cash dividends. The retained earnings have been already exhausted. Therefore, the firm will use new common stock as the form of common equity financing. Additionally, the firm’s marginal tax rate is 40 percent.

1. Maximum acceptable payback period of this project is 3 years. Calculate the payback period for this project.
2. Calculate the project’s NPV.
3. Calculate the project’s IRR.
4. Should the firm make the investment? Why?

Answer 1

a)

Year	After Tax Operating Cash Flows	Cummulative
1	$                                             1,800,000	$ 1,800,000
2	$                                             2,900,000	$ 4,700,000
3	$                                             2,700,000	$ 7,400,000	Since cost of $5,000,000 lies between $7,400,000 and $ 4,700,000, Payback period is between 2 and 3 years.
4	$                                             2,300,000	$ 9,700,000
	Payback period = 2 +	(5,000,000 - 4,700,000)
		(7,400,000 - 4,700,000)
	= 2 +	0.11111111
	=2.111	Years

b)

Cost of Debt =	Interest + (Premium/No. of years)
	(Sale proceeds + Redemption Value) /2
Cost of Debt =	90 + (10/15)
	(960 + 1010) /2
Cost of Debt =	9.20%
Cost of Debt(after tax) =	9.20%	* ( 1 - 40%)=	5.52%

Cost of Preference Stock =	Dividend
	Sale proceeds
Cost of Preference Stock =	$ 80 * 12%
	($ 80 - $3)
Cost of Preference Stock =	12.47%

Value of Equity Stock =	Dividend * ( 1 + Growth)
	(KE - Growth)
$ 10 - $ 2 - $1 =	0.87 * ( 1 + 0.05)
	( KE - 0.05)
KE -0.05 =	13.05%
Cost of Equity =	18.05%

Source of Capital	Target Market	Cost of Funds	Weighted Average Cost of Capital
Proportions
Long-term debt	40%	5.52%	2.22%
Preferred stock	10%	12.47%	1.25%
Common stock equity	50%	18.05%	9.03%
			12.50%

Year	After Tax Operating Cash Flows	Present Value @12.50%	Present Value of Cash Flows
1	$                                             1,800,000	0.889	$                              1,600,000.00
2	$                                             2,900,000	0.790	$                              2,291,358.02
3	$                                             2,700,000	0.702	$                              1,896,296.30
4	$                                             2,300,000	0.624	$                              1,435,878.68
		Net Inflows	$                              7,223,533.00
		Net OutFlows	$                              5,000,000.00
		Net Present Value =	$                              2,223,533.00

c) IRR is the rate of return implicit in a transaction such that the Net present value becomes zero if the IRR is used to discount the future flows.

Year	After Tax Operating Cash Flows	Present Value @31.528%	Present Value of Cash Flows
0	$                                      -5,000,000.00	1	$                             -5,000,000.00
1	$                                             1,800,000	0.760	$                              1,368,529.89
2	$                                             2,900,000	0.578	$                              1,676,337.90
3	$                                             2,700,000	0.439	$                              1,186,613.04
4	$                                             2,300,000	0.334	$                                  768,519.64
			$                                               0.48

Hence, IRR = 31.528%

d) Yes, the firm should make investment as the project has a lower payback 2.11 Years as opposed to the maximum payback acceptable to the company of 3 years. The project also has a huge 31.528% IRR as opposed to the Cost of Capital of the Firm of 12.50% resulting in a huge NPV value of the project.