Question

Celest Corporation’s stock returns have a ? with the market of 1.21. The company has issued perpetual debt, and pays interest at the rate of 11%. The market value of Celest’s debt is 24M. There are 4M shares of Celest’s stock outstanding, and the price per share is $15. The tax rate is 34%, the Treasury bill rate of return is 7%, and the risk premium is 8.5%. Celest must decide whether to purchase additional capital equipment (this will expand the scale of Celest’s current operations). The cost of the equipment is $27.5M The expected after-tax cash flows are 9M for a period of 5 years. Assuming that Celest’s ratio of debt to equity will remain the same with the purchase of the equipment, and that it will not change for the next five years. Should Celest purchase the equipment?

Answer 1

First we have to calculate the WACC

Total debt = 24 Million

Total Equity = 4 Million * 15 = 60 Million

Total Value = 84 Million

Weight of debt = 24/84 = 0.2857

Weight of equity 1-0.2857 = 0.7143

After tax Cost of debt = 11*(1-0.34) = 7.26%

Cost of equity = rf + beta * risk premium = 7 + 1.21*8.5 = 17.285%

WACC = 0.2857*7.26 +0.7143*17.285 = 14.42%

WACC = 14.42%

Now, we calculate the NPV of the cash flows at 14.42% discount rate as shown in the ebale below:

Year	Cash flow (in $ Million)
0	-27.5
1	9
2	9
3	9
4	9
5	9
NPV	$                                    3.09

NPV = $3.09 Million

Since NPV is positive, Celest should purchase the equipment