Question

Question 4 I. The Star Company's year-end balance sheet is shown below.

cash$120 Debtors $240 stock $360 Plant and equipment $2160 Total Assets=$2880

long term debt $1152 common equity $1728 Total libailities 2880

Its cost of common equity is 15%, its before-tax cost of debt is 12%, and its corporate tax rate is 35%. Assume that the firm's long-term debt sells at par value. The firm has 576 shares of common stock outstanding that sell for $4.00 per share. Calculate Care Company's cost of capital (WACC). II. A firm with a 12% WACC is evaluating two Projects for this year's capital budget. After Tax cash flows, including deprecation, are as follows: Project L (6000) 1000 1500 1800 3000 4000 Project M (6000) 3500 3800 2000 1000 1000

a) What is NPV of both projects? b) What is IRR of both projects? c) If the projects are mutually exclusive, which project will you select using the NPV technique? Give reasoning.

kindly tell calculator key if applicable

Answer 1

1. WACC=(weight of debt*after tax cost of debt)+(weight of equity*cost of equity)

market value of debt=$1152

Market value of equity=shares*price=576*4=$2304

Total value=$1152+$2304=$3456

Market value of debt=$1152/$3456=33.33%

Market value of equity=$2304/$3456=66.67%

after tax cost of debt=before tax cost of debt*(1-tax rate)=12%*(1-35%)=7.8%

Cost of equity=15%

WACC=(33.33%*7.8%)+(66.67%*15%)=12.6%

2. NPV can be found using NPV function in EXCEL

=NPV(rate, Year1 to Year5 cashflows)-Year0 cashflow

rate=12%

=IRR(values)

=IRR(Year0 to Year5 cashflows)

Project M has to be selected because of higher NPV than Project L.