Glen has a B.S. in accounting from CWU (2007) and passed the CPA exam (2008). He

Question

Glen has a B.S. in accounting from CWU (2007) and passed the CPA exam (2008). He has been in public accounting for 2 years. During that time he earned an MBA from Seattle U. He would like to be the CFO of a company someday--maybe Slamdunk Sporting Goods-- and this is an opportunity to get onto that career track and to prove his ability.

As Glen looks over the financial data collected, he is trying to make sense of it all. He already has the most difficult part of the analysis complete -- the estimation of cash flows. Through some internet research and application of finance theory, he has also determined the firm

Explanation / Answer

After tax cost of debt = Interest rate(1 -tax)

                                     = 8 (1-.38) = 4.96%

Cost of prferred stock = Dividend*100 / current market price

                             = (100*10.5%)*100 /114

                             = 9.21%

Cost of equity (DCF approach ) =current price = Dividend( 1+growth)/(Cost of equity -growth)

                                               66.80=3.95(1+.058)/(X-.058)

                                              X-.058 = 4.1791/66.80

                                           X= .0626+.058

                                    X = 12.06%

Cost of equity ( CAPM) =Risk free rate+ beta*(retuen on market- risk free rate)

                                =2.80% + .96(12.50-2.80)

                               = 2.80+9.312

                              =12.112%

Cost of equity (Bond yield risk premium approach ) = Bond yield rate+Risk premium

                                                                             =10 + 2

                                                                             = 12 %

**Bond yeild = [Interest +(Redemption price-issue price)/Number of years ]/[(Redemption price+issueprice)/2]

                  =[ 40 + (1000-876)/18]/[(1000+876)/2]

                 = [40+6.889]/[938]

                   = 4.9998% (or 5 %semiannually )

So annual yield = 5* 2 =10%

In case Interest is paid semiannually(100*8% = 80/2 =40] years get double and yield rate gets half

Now cost of equity is a minimum expectation of shareholders .since cost of equity is least in bond yeild premium approach we will take cost of equity = 12%

WACC:

Overall WACC= (1.736+.921+6.6) = 9.257% ( 9.26 %approx)

WACC for each project

Project A (high risk )=9.26 +2% = 11.26%

Project B (Average) = 9.26%

Project C(Low) = 9.26% - 2% = 7.26%

Project D= 9.26%

2)NPV for each project = present value of cash flow -Initial investment

Project A= Present value@ 11.26% ,4years(present value table) - initial inv.

               = 21353315.51 - 20800000

              = $553315.51

Project B = Present value @ 9.26%,4 years - II

            =20782411.99 - 19900000

           =$882411.99

Project C = Present value @7.26%.4 years -II

              =20883458-21600000

     = $(716541.59)

Project D = Present value@ 9.26%,4years -II
              =20331903.25 - 15100000

             = $ 5231903.25

On the basis of NPV , project D should be selected

weights(A) cost(B) weighted average(a*B) Debt .35 4.96 1.736 Preferred stock .10 9.21 .921 equity .55 12 6.6

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