Question

Kiwi Helicopters Ltd has a target capital structure of 70% ordinary common shares and 30% debt. They issued a twenty-year, 5% bond 10 years ago. The bond currently has a yield-to-maturity of 7.5%. The ordinary common shares are currently selling for $45. They have a beta of 1.75 and are expected to pay a $3.25 dividend next year. The firm has a 30% marginal tax rate. The market has an expected return of 12%. Treasury bills are currently paying 2%.

Required: (a) Calculate the appropriate discount rate for the average project for Kiwi Helicopters Ltd.

Kiwi Helicopters Ltd is considering a project that will provide after-tax cash flows of $225,000 for the next 7 years. The project will cost $1,000,000 and will have a salvage value of $200,000.

Required: (b) Should they do the project? Show your workings and justify your answer.

Answer 1

(a) The appropriate discount rate for the average project for Kiwi Helicopters Ltd is WACC of firm

WACC = wd *kd + we * re

Where,

wd is the weight of debt = 30% or 0.3

we is the weight of common equity = 70% or 0.7

Cost of debt (yield to maturity) = 7.5%

And marginal tax rate = 30%

Therefore, the after-tax cost of debt Kd = 7.5%* (1- 0.30) = 5.25%

Required rate of return or cost of equity = risk free rate (rRF) + beta of stock *[Expected market return (rM) – risk free rate (rRF)]

Where,

Required rate of return of stock re =?

Yield of current treasury bills or Risk free rate (rRF) = 2%

Beta of the stock = 1.75

The expected return on the market rM = 12%

Now putting all the values into formula, we get

Required rate of return or cost of equity = 2% + 1.75 * (12% - 2%)

= 19.50%

Therefore cost of equity is 19.50%

Therefore

WACC = 0.3 * 5.25% + 0.7 * 19.50% = 15.225%.

The appropriate discount rate for the average project for Kiwi Helicopters Ltd is 15.225%

(b) To know that the project is acceptable or not, we have to calculate internal rate of return (IRR) of the project. If the IRR of the project is more than the WACC then the project is acceptable otherwise not.

Internal rate of return (IRR) Calculation:

Year	Cost (A)	after-tax cash flows (B)	salvage value (C )	Net cash flow (-A + B +C)
0	$        1,000,000			$              (1,000,000)
1		$                       225,000		$                    225,000
2		$                       225,000		$                    225,000
3		$                       225,000		$                    225,000
4		$                       225,000		$                    225,000
5		$                       225,000		$                    225,000
6		$                       225,000		$                    225,000
7		$                       225,000	$        200,000	$                    425,000
IRR				15.35%

As the IRR (15.35%) is more than the WACC (15.225%) of the firm, therefore the project is acceptable.

Formulas used in excel calculation: