Scotty Doesn\'t Know, a unique t-shirt company, has 1,000,000 shares of stock cu

Question

Scotty Doesn't Know, a unique t-shirt company, has 1,000,000 shares of stock currently
trading at $60 per share. The company has issued 20,000 bonds, each with market value
$974.50 and yield to maturity 8.5%. SDK's asset beta is 1.3, the risk free rate is 5%, and the
expected market risk premium is 7%.
(a) Assuming there are no corporate taxes, what is the rm's weighted average cost of capital
(WACC)?
(b) Now, assume that a 35% corporate tax rate applies to this rm. All of the information
given in the introduction still applies, but your answer to part (a) doesn't necessarily
apply. Recalculate the WACC under this assumption and state whether this rm would
be willing to invest in a project that costs $1,000,000 today and that will have a net
(after-tax) payo of $1,350,000 exactly one year from now? (You may assume the project
is as risky as the rest of the rm)

Explanation / Answer

a. Equity, E= 60*1000000=60000000

Cost of equity, re = 5% +1.3*7%= 14.10%

Debt,D = 20000*974.50=19490000.0

Cost of debt, rd= 8.5%

weighted average cost of capital= E/(E+D)*re + D/(E+D)*rd*(1-tax)

weighted average cost of capital=60000000/(60000000+19490000.0)*14.10% + 19490000.0/(60000000+19490000.0)*8.5%= 12.73%

b. weighted average cost of capital=60000000/(60000000+19490000.0)*14.10% + 19490000.0/(60000000+19490000.0)*8.5%*(1-35%)= 12.00%

NPV of project = -1,000,000 +1,350,000/(1+12%)=$205383.92

Yes, rm would be willing to invest in a project as NPV is positive

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