Question

Based upon the following facts calculate the Weighted Average Cost of Capital (WACC) for Student Success Corporation (SSC):

PART 1 – WACC

• Tax rate = 40%
• Debt Financing: $10,000 Face Value 10-Year, 5% Coupon, Semiannual Non-Callable Bonds Selling for $11,040 New bonds will be privately placed with no flotation cost.
• Common Stock: Current Price $40; Current Dividend = $3.00 and Growth Rate = 5%.
• Common Stock: Beta = 1.1; Risk Free Rate 2.0%; Required Return of the Market 7%
• Capital structure:  40% Debt, 60% Common Equity

1. What is the cost of debt?
2. What is the cost of equity – use both CAPM and the Dividend Model?
3. What is the WACC – for Equity you can use either answer above or an average?

PART 2 – Capital Budget

If SSC is deciding upon whether to approve a capital project and the cash flows are as follows:

Year 0 (initial investment)           $2,000

Year 1 Cash Flow                            $1,000

Year 2 Cash Flow                            $600

Year 3 Cash Flow                            $400

Year 4 Cash Flow                            $4,000

Calculate:

1. Net Present Value (NPV)                          ____________________________
2. Internal Rate of Return (IRR)                 ____________________________
3. Payback Period                                           ____________________________

Remember to use the WACC from above for the NPV and to compare to the IRR.  Should this project be approved and why or why

Answer 1

PART 1

Cost of debt

Using financial calculator

Input: FV= 10000, N=10*2=20, PMT=5%*10000/2 = 250

PV=-11040

Solve for I/Y as 1.87

YTM = 1.87%*2= 3.7436%

After tax cost = 3.7436%*(1-40%) = 2.25%

Cost of equity: CAPM= Rf+Beta*(Rm-Rf)

= 2%+1.1*(7%-2%) = 7.5%

Dividend model = D1/Price+g

= 3*105%/40+ 5%

=12.875%

Average of two = 10.1875%

WACC = 40%*2.25%+60%*10.1875%= 7.01%

PART 2

NPV	$2,835.33
IRR	45.31%
Payback	3

Since IRR is more than the cost of capital, the project is profitable.

Working

Year	Cash flow	Cumulative CF
0	-2000	-2000
1	1000	-1000
2	600	-400
3	400	0
4	4000	4000