Question

) Kirksville Inc. has 1,000 bonds outstanding that are selling for $911.66 each. The bonds carry a 6.0 percent coupon, pay interest semi-annually, and mature in 14 years. The common stock is priced at $40 a share and there are 40,000 shares outstanding. This year, the company paid an annual dividend in the amount of $2.00 per share. The dividend growth rate is estimated to be 5.0 percent indefinitely. The company is considering a project that is equally as risky as the overall company. This project has initial costs of $600,000 and operating cash flows of $150,000 a year for the next 7 years and salvage value of $100,000 at the end of 7 years. The net working capital (NWC) is expected to increase by $30,000 a year until the end of the project life. The project will be depreciated straight-line to zero over the project’s 7-year life. The tax rate is 20%. (a) (14 points) What is Kirksville’s weighted average cost of capital? (b) (7 points) What is the net present value (NPV) of this project? Should you accept the project? Explain why. (c) (4 points) What is the internal rate of return (IRR) of this project? Should you accept the project if you apply the IRR decision rule?

Answer 1

A) First we will find out the cost of equity (r)

Current Price = Dividend in Year 1 / (r - g ) ===> Po = Do*(1+g)/(r-g)

Po = $40 ; Do =$2 ; g = 5%; get r using above equation

r = 0.1025 = 10.25%

Cost of Debt = (1+0.06/2)^2 - 1 = 6.09%

WACC = Weight of Debt* Cost of Debt*(1- Tax rate) + Weight of Equity*Cost of Equity

Debt Value = 1000*911.66 = $ 911660

Equity Value = 40*40,000 = 1600000

Weight of Debt = 911660 / (911660 + 1600000) = 0.3629

Weight of Equity = 1 - 0.3629 = 0.6371

WACC = 0.3629*6.09*(1-0.2) + 0.6371*10.25 = 8.298 %