Question

Your company is considering an expansion project that will cost $1.5 million. The project will generate after-tax cash flows of $175,000 per year for 6 years. Your company is expected to pay an annual dividend in the amount of $2.50 per share next year and the current price of share is $15. The dividend growth rate is 2.5%. The bonds carry an 8 percent coupon, pay interest annually, and mature in 4 years. The bonds are selling at 104% of face value. The firm is in the 30% tax bracket and the target debt-equity (D/E) ratio is 0.6. What is the NPV for the project and should you accept the project? Calculate the cost of debt using EAR (Effective Annual interest Rate). What is the fraction of each securities (Round to the three decimal places.) A) x d e b t = 0.375 , x c s = 0.625 B) x d e b t = 0.475 , x c s = 0.525 C) x d e b t = 0.525 , x c s = 0.475 D) What is the pre-tax cost of debt and cost of common equity? (Round to the two decimal places.) A) k d e b t = 4.54 % , k c s = 23.68 % B) k d e b t = 5.67 % , k c s = 20.34 % C) k d e b t = 6.82 % , k c s = 19.17 % D) What is the WACC (Round to the two decimal places.) A) 14.24% B) 13.77% C) 16.43% D) 17.65% What is the NPV of this project and should you invest in this project (Round to the nearest dollar.) A) -$53,113, No B) $815,175, Yes C) $53,113, Yes D) -$815,175, No

Answer 1

1) D/E = 0.6 => Debt = D/E / (1 + D/E) = 0.6 / 1.6 = 0.375, Equity = 1 - 0.375 = 0.625

Hence, A is correct.

2) Cost of debt can be calculated using I/Y function on a calculator

N = 4, PV = -104, FV = 100, PMT = 8 => Compute I/Y = 6.82% = kd

Cost of equity, ke = D1 / P + g = 2.5 / 15 + 2.5% = 19.17%

Hence, C is correct

3) WACC = wd x kd x (1 - tax) + we x ke = 0.375 x 6.82% x (1 - 30%) + 0.625 x 19.17% = 13.77%

Hence, B is correct.

4) NPV can be calculated using PV function

N = 6, I/Y = 13.77%, PMT = 175,000, FV = 0

=> Compute PV = $684,824

=> NPV = 684,824 - 1,500,000 = -815,175

Hence, D is correct.