Question

You are hired as a consultant and provided with the following information regarding WolfPac Co.

• The company currently has 100,000 share of common stocks trading at a price of $60. The expected return is 18%.

• The company's current debt (book value) is $4 million and was $6 million the year before. The interest paid during last year was $450,000.

• The company had $4,000,000 last year in pre-tax profit, and paid tax of $1,000,000.

(1) What is the company's WACC?

(2) What is your suggestion to the company about a new project that requires investment of $380,000 and generates annual cash flow of $70,000 for the next 10 years? (Create the project's cash flow stream!)

(3) Show and explain how your answer to part (2) changes if the tax rate changes from 0% to 50% by 10%.

Answer 1

I) Calculation of WACC on Book Value Basis

Cost of Equity = 18%

Cost Debt = Interest/ Debt amount

= 450000/6000000*100

= 7.5%

Tax Rate = Tax Amount/ Pretax profit

= 1000000/4000000

= 25%

Cost of debt after tax = 7.5 (1-0.25)

= 5.625%

Sources Amount Weights Rate WACC

Equity 1000000 20% 18% 3.6

Debt 4000000     80% 5.625% 4.5

Total 5000000 8.1%

II)

Year Cash Flows Present Value @ 8.1% DCF

1. 70000 0.93 64755   

2. 70000 0.86 59903

3. 70000 0.79 55414

4. 70000 0.73 51262

5. 70000 0.68 47421

6. 70000 0.63 43868

7. 70000 0.58 40581

8. 70000 0.54 37540

9. 70000 0.5 34727

10   70000 0.46 32125

Total 467594

Investment 380000

Profit from Investment 87594   

As the project generates the profit , therefore it is advisable to invest in the project

Note: Tax rate is considered 0%

III) Evlauation of answer determined in step II cosidereding Tax Rate at 50%

Cash Flows 70000 (1-0.5)= 35000

Cash Flows * Present Value factor

= 35000* 6.68

= 233797

Loss from Investment = 380000- 233797

= 146203

it is not advisable to invest if Tax rate changes from 0 to 50%