Question

Evaluate the following investment project:

- Initial Investment = $ 30 million
- Useful life = 7 years
- Salvage value = $ 3 million
- Net Cash Flows: Years 1-7: $ 9 million
The capital structure of the company requires financing: 40% with long-term debt through a bond, and 60% with its own capital, starting with Retained Earnings and if necessary, carry out a new share issue which will cost 3% more than Retained Earnings. Some additional information:

- Corporate tax rate (ISR) = 30%.
- Retained earnings: $ 10 million
- You can issue bonds for up to 50 million: The cost of the bond is 12%.
- The dividend authorized to pay next year is $ 4.00 per share, having grown at 5% per year and is expected to continue at this rate. The current share price is $ 36.00
- You can make a New Issue of Shares for up to 20 million.

a) What is the company's WACC?

b) What is the present value of the cash flows

Answer 1

1. WACC = COST OF EQUITY* %EQUITY +COST OF DEBT *%DEBT *(1-TAX RATE ) +COST OF PREFERRED STOCK *%PREFERRED STOCK .

COST OF PREFERRED STOCK r = DIVIDEND / PRICE .

OR

WACC=E/V*R_e+D/V*R_d*(1-T_c)

Re =Cost of equity

R_{d= cost of debt}

E =market value of the frim's equity

D=market value of the frim's debt

V=E+D

E/V=percentage of financing that is equity

D/V=percentage of financing that is debt

Tc= corporate tax rate

1. Computation of cost of preferred stock,r=Dividend /Price

Dividend =4+5%=4.2

r=4.2/36=0.1166

WACC= [ .6*0.03+0.4*0.12] (1-.30) +0.1166

=0.1772 OR 17.72%OR 18%(Taking 18% for calculation)

2 .PRESENT VALUE OF CASH FLOWS

PRESENT VALUE = CASH FLOW /(1+i)ⁿ

here i is the interest rate , n= no;of years

so present value of cash flow =9 million /(1+0.18)⁷= 9 million / (1.18)⁷

^{= 9 million /3.185 = $ 28,25,745.68}

hence the present value of cash flow is $28,25,745.68