Question

Chirping Burger Corporation considers an expansion project. It currently has 10 million outstanding shares trading at $30 per share. Equity has an estimated beta of 1.4. The risk-free rate is 2%, while the market risk premium is 5%. It also has 200,000 outstanding bonds with 20 years to maturity, 8% coupon rate, $1,000 par, currently trading at par. The corporate tax rate is 30%. The project will require an investment if $112 million and will produce a net after tax cash flow of $12 million per year for 20 years.

a. Should Chirping Burger accept the project?

b. Prior to the investment decision, Chirping Burger bonds were downgraded, and their price dropped to 70.122% of par. Should Chirping Burger go ahead with the expansion?

Answer 1

	Value	Weight	Cost
Equity	300	60%	9.00%
Debt	200	40%	8.00%
Total	500	WACC	7.64%

Value of equity = 10 x 30 = 300 m, Value of debt = 0.2 x 1,000 = 200 m

Cost of equity, re = Rf + beta x MRP = 2% + 1.4 x 5% = 9%, Cost of debt, rd = 8%

WACC = wd x rd x (1 - tax) + we x re

= 40% x 8% x (1 - 30%) + 60% x 9% = 7.64%

PV of cash inflows can be calculated using PV function

N = 20, PMT = 12, FV = 0, I/Y = 7.64%

=> Compute PV = $121.04 million

NPV = 121m - 112 = $9.04 million

As NPV > 0, accept the project... a)

If bond price = 1,000 x 70.122% = $701.22, cost of debt can be calculated using I/Y function on a calculator

N = 20, PMT = 8% x 1000 = 80, PV = -701.22, FV = 1000

=> Compute I/Y = 12.00% = rd

=> New WACC = 8.76%

=> New NPV = - $0.56 m

As NPV < 0, reject the project... b)