Question

1. Use the following information provided and the answers to the questions below to predict what the weighted average cost of capital might be in the future. Then, use the WACC to make an informed decision about whether or not the company should invest in a new project. Publicly traded companies are required to produce annual accounting reports (10-K) for the SEC detailing the financial operations of the past year. Suppose that you look up a company and find that they report $6,427 million worth of long-term debt and $882 million worth of shareholders equity. Then you look at yahoo.finance.com and find that the stock is currently trading for $62.50 per share and that there are 200 million shares outstanding. As the result of the most recent tax plan, the company will pay a fixed 21% in taxes. There is no preferred stock.
a. What is the market value of equity?

62.50 x 200M = 12500

b. Use the market value of equity to find the value of the firm. What is the weight of debt and equity?

V= D+E+P= 18927
W_E= E/V= 12500/18927=.66

WD = 6427/18927= .34

c. If the most recent bond issued is currently trading for $1120, has a 6.625% annual coupon, and has 8 years left until maturity what is the company’s current cost of debt?
d. If the most recent annual dividend was $4 and the dividend is expected to grow at a constant rate of 5.5% going forward, what is the company’s current cost of equity?
e. Assume that past information about the company (cost of debt, cost of equity, etc) is a good indicator of future information. Based on the above information what will to company’s WACC be for future projects?
f. Now consider the following project. At the end of the first year of the project they could earn net operating cash flow of $1 million, $2 million the following year and, $3 million in the last year. If the project requires an initial investment (upfront cost) of $5 million, what is the project’s payback, NPV, and IRR? Based on this information, would you advise them to accept the project? Why?
g. The company is considering a different project that could earn net operating cash flows of $500,000 per year for the next 10 years. The project costs $4 million. What is the project’s payback, NPV, and IRR? Would you advise them to accept the project? Why?

Answer 1

a] and b] are solved correctly

c]

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

YTM is calculated using RATE function in Excel with these inputs :

nper = 8 - 8 years to maturity

pmt = 1000 * 6.625% - annual coupon payment = face value * coupon rate. This is entered with a positive sign because it is a cash inflow to the bondholder

pv = -1120 - current price of bond. This is entered with a negative sign because it is a cash outflow to the buyer of the bond

fv = 1000 - face value of the bond. This is entered with a positive sign because it is a cash inflow to the bondholder

RATE is calculated to be 4.78%

cost of debt = 4.78% * (1 - 21%) = 3.78%

d]

cost of equity = (next year dividend / current share price) + constant growth rate

cost of equity = (($4 + 5.5%) / $62.50) + 5.5% = 12.25%

e]

WACC = (weight of debt * cost of debt) + (weight of equity * cost of equity)

WACC = (0.34 * 3.78%) + (0.66 * 12.25%) = 9.37%

f]

Payback period is the time taken for the cumulative cash inflows to equal the initial investment

From the table below, we can see that the payback period is between 2 and 3 years. The exact payback period is :

2 + ($2,000,000 / $3,000,000) = 2.67 years

NPV is calculated as the sum of the present values of each cash flow. NPV is -$120,564 (NPV is negative)

IRR is calculated using the IRR function. IRR is negative at -1.06%

It is advised not to accept the project as the NPV is negative

g]

payback period = 8 years

NPV = -$842,776

IRR = -4.66%

It is advised to not accept the project as NPV is negative