Mars Car company has capital structure made up for 40% debt and 60% equity and a

Question

Mars Car company has capital structure made up for 40% debt and 60% equity and a tax rate of 30%. A new issue of $1,000 par bonds maturity in 20 years can be issued with a coupon of 9% at a price of 41,098.18 with no flotation costs. The firm has no internal equity available for investment at this time, but can issue new common stock at a price of $45. The next expected dividend on the stock is $2.70. The dividend for Mars Co. is expected to grow at a constant annual rate of 5% per year indefinitely. Flotation costs on new equity will be $7.00 per share. The company has the following independent investment projects available:

Project Initial Outlay IRR
1 $100,000 10%
2 $10,000 8.5%
3 $50,000 12.5%


Which of the above projects should the company take on?
a) Project 3 only
b) Projects 1,2 and 3
c) Projects 1 and 3
d) Projects 1 and 2

Explanation / Answer

Computing the cost of debt: According to the given information, Weight of debt = 40% Weight of equity = 60% Issue price of the bonds = $41,098.18 Face value of the bond = $1000 Years to maturity = 20yrs Coupon rate = 9% Annual coupon payment = Face value * Coupon rate = $1000 * 9% = $90 Computing the cost of debt using excel sheet: Step1: Go to excel and click "insert" to insert the function. Step2: Select the "Rate" function as we are finding the yield to maturity in this case. Step3: Enter the values as Nper = 20; PMT = -90; PV = 41098.18; FV = -1000 Step4: Click "OK" to get the desired value. The value comes to "-15.05%" Therefore, the Yield to maturity is -15.05% Computing the cost of equity using Dividend growth model: Ke = (D1 / P0) + g where Ke = Cost of equity P0 = Current price of share g = Growth rate Ke = [$2.70 / ($45 - $7)] + 0.05 = ($2.7 / $38) + 0.05 = 0.071 + 0.05 = 0.121 or 12.1% Therefore, the cost of equity is 12.1% Now, we have to calculate the cost of capital using the formula, Cost of capital = Weight of debt * Cost of debt * (1 - Tax rate ) + Weight of equity * Cost of equity = 0.40 * -0.1505 * (1 - 0.30) + 0.6 * 0.121 = -0.04214 + 0.0726 = 0.03046 or 3.05% Therefore, Cost of capital is 3.05% According to the given information, Weight of debt = 40% Weight of equity = 60% Issue price of the bonds = $41,098.18 Face value of the bond = $1000 Years to maturity = 20yrs Coupon rate = 9% Annual coupon payment = Face value * Coupon rate = $1000 * 9% = $90 Computing the cost of debt using excel sheet: Step1: Go to excel and click "insert" to insert the function. Step2: Select the "Rate" function as we are finding the yield to maturity in this case. Step3: Enter the values as Nper = 20; PMT = -90; PV = 41098.18; FV = -1000 Step4: Click "OK" to get the desired value. The value comes to "-15.05%" Therefore, the Yield to maturity is -15.05% Computing the cost of equity using Dividend growth model: Ke = (D1 / P0) + g where Ke = Cost of equity P0 = Current price of share g = Growth rate Ke = [$2.70 / ($45 - $7)] + 0.05 = ($2.7 / $38) + 0.05 = 0.071 + 0.05 = 0.121 or 12.1% Therefore, the cost of equity is 12.1% Now, we have to calculate the cost of capital using the formula, Cost of capital = Weight of debt * Cost of debt * (1 - Tax rate ) + Weight of equity * Cost of equity = 0.40 * -0.1505 * (1 - 0.30) + 0.6 * 0.121 = -0.04214 + 0.0726 = 0.03046 or 3.05% Therefore, Cost of capital is 3.05% Computing the cost of debt using excel sheet: Step1: Go to excel and click "insert" to insert the function. Step2: Select the "Rate" function as we are finding the yield to maturity in this case. Step3: Enter the values as Nper = 20; PMT = -90; PV = 41098.18; FV = -1000 Step4: Click "OK" to get the desired value. The value comes to "-15.05%" Therefore, the Yield to maturity is -15.05% Computing the cost of equity using Dividend growth model: Ke = (D1 / P0) + g where Ke = Cost of equity P0 = Current price of share g = Growth rate Ke = [$2.70 / ($45 - $7)] + 0.05 = ($2.7 / $38) + 0.05 = 0.071 + 0.05 = 0.121 or 12.1% Therefore, the cost of equity is 12.1% Now, we have to calculate the cost of capital using the formula, Cost of capital = Weight of debt * Cost of debt * (1 - Tax rate ) + Weight of equity * Cost of equity = 0.40 * -0.1505 * (1 - 0.30) + 0.6 * 0.121 = -0.04214 + 0.0726 = 0.03046 or 3.05% Therefore, Cost of capital is 3.05% Now, we have to calculate the cost of capital using the formula, Cost of capital = Weight of debt * Cost of debt * (1 - Tax rate ) + Weight of equity * Cost of equity = 0.40 * -0.1505 * (1 - 0.30) + 0.6 * 0.121 = -0.04214 + 0.0726 = 0.03046 or 3.05% Therefore, Cost of capital is 3.05% According to IRR analysis, the project with the highest IRR should be selected. Then Project-3 should be selected. Here, the required return is 3.05% and the Project's IRR is 12.5%. The initial outlay for Project-1 is more and the IRR is less when compared to other projects. For Project-2, the intial outlay is less and the IRR is also less. Therefore, the project-3 should be considered and recommended for investment.

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