can someone help to solve this problem? 2-The capital structure of a company con
ID: 2654734 • Letter: C
Question
can someone help to solve this problem?
2-The capital structure of a company consists of debt, common equity, and preferred stock. The firm has 10 million shares of common stock outstanding, 500,000 shares of preferred stock outstanding, and 200,000 bonds outstanding with $1,000 par value each. The common stock currently trades for $50 per share and has a beta of 1.80, the preferred stock pays annual dividend of $10 per share in perpetuity and currently sells for $100 per share, and the bonds are currently sell for 110 percent of par. The market risk premium is 6 percent, Treasury bills are yielding 4 percent, and the firm’s tax rate is 35 percent. The before-tax cost of debt is 8 percent.
a) What is the firm’s weighted average cost of capital (WACC or RWACC)?
b) The firm is evaluating a new 5-year investment project that has the same risk as the firm’s typical project. The project requires an initial investment of $20 million. It is expected to generate annual after-tax cash flows of $8 million for 5 years. The project has no net working capital requirement and no salvage value. Find the net present value (NPV) of the project.
Explanation / Answer
We first need to compute weight of each source:
Source
Price
Units
Price x Units
Weight
Debt
1100
200,000
220000000
0.2857
Common stock
50
10,000,000
500000000
0.6494
Preferred stock
100
500,000
50000000
0.0649
770000000
Now we will compute cost of each source:
Cost of debt:
Cost of debt = before tax cost x (1-t)
Kd = 8% x(1-0.35) = 5.20%
Cost of common stock
Ke = Rf + MRP xbeta
= 4% +6% x1.80
= 14.80%
Cost of preferred stock
Kp = Preferred dividend/ price
= 10/100
= 10%
Calculation of WACC
WACC = Kd xWd + Kp x Wp + Ke x We
=5.2% x 0.2857 +10% x 0.0649 +14.80% x0.6494
= 11.75%
Calculation of NPV
Year
Cash flow
PV Factor 11.75%
PV
0
-20000000
1.000
-20000000
1
8000000
0.895
7158836.7
2
8000000
0.801
6406117.8
3
8000000
0.717
5732543.9
4
8000000
0.641
5129793.2
5
8000000
0.574
4590419
9017710.7
Hence Npv of the project is 9,017,710.70
Source
Price
Units
Price x Units
Weight
Debt
1100
200,000
220000000
0.2857
Common stock
50
10,000,000
500000000
0.6494
Preferred stock
100
500,000
50000000
0.0649
770000000
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