Question

The capital structure of a firm consists of debt and equity. The firm has 100,000 bonds outstanding that are selling at par value. The par value of the bonds is $1,000. Bonds with similar characteristics are yielding a before-tax return of 7%. The company also has 5 million shares of common stock outstanding. The stock has a beta of 1.30 and sells for $50 a share. The rate of return on U.S. Treasury bills is 5% and the market rate of return is 11 percent. The firm’s tax rate is 25%.
a) Find the company’s weighted average cost of capital (WACC or R_WACC).
b) The firm is considering a new project that is expected to generate annual net after-tax cash flows of $2 million for five years. The project requires an initial investment of $5 million. It has the same risk as the overall firm. Assume no net working capital requirement and no salvage value. Find the net present value (NPV) of the project.

Answer 1

a)

Cost of debt = before-tax yield*(1-tax rate) = 7%*(1-0.25) = 5.25%

Cost of equity = Rf +(Beta*(Market return - Rf) = 5% + (1.3*(11%-5%)) = 12.8%

Weights = Amount invested/Total Capital

	Number Outstanding	Price	Number Outstanding*Price	Weights	Cost	Weights*Cost
Equity	100000	1000	100000000	0.29	5.25%	1.50%
Bond	5000000	50	250000000	0.71	12.80%	9.14%
		Total Capital	350000000		WACC	10.64%

b)

NPV = Sum of PV of all the cash flows

PV = Cash Flow at n/ ((1+r)^n)

Discount rate = 10.64%

Years	Cash Flows(In million)	PV
0	-5	-5
1	2	1.81
2	2	1.63
3	2	1.48
4	2	1.33
5	2	1.21
NPV	2.46