Perry\'s Products, a privately-held company, has two operating divisions: Steel,

Question

Perry's Products, a privately-held company, has two operating divisions: Steel, which accounts for 60% of firm value; and, Oil, which accounts for 40% of firm value. Perry's Products is financed with debt ($8 million) and equity {$4 million); the equity has a beta of 2.30. Perry's Products has gathered the following data on two competing firms, each of which is very similar to the corresponding division of Perry's: Assume the debt of ALL companies is risk-free. Further, assume the risk-free rate of return is 4%, the expected return on the market portfolio is 10%, and the standard deviation of return on the market portfolio is 20%. Calculate the Weighted Average Cost of Capital (WACC) of Perry's Products. Perry's Products' Oil division is considering a project with the following expected cash flows: What is the Internal Rate of Return (IRR) of this project (to the nearest percent)? As judged by the IRR method, is this a good project or a bad project? Briefly justify your answer.

Explanation / Answer

1) expected return on equity = risk-free rate + beta * (expected return on the market - risk-free rate)

= 4 + 2.30*(10 -4 ) = 17.8%

WACC = wd(rd)+ wc(rs)

Weight debt (8/12) = 66.67%

Weight equity 4/12 = 33.34%

YTM 4

WACC = .6667*4 + .3334*17.8 = 8.60%

2) beta for company's oil division = union oil equity beta/(1+(debt/(debt + equity of union oil) )* ( 1+(debt/(debt + equity of perry's)

= 1.5 /(1 + 0.2) * ( 1 + 8/12) = 2.0833

expected return on equity for oil division= risk-free rate + beta * (expected return on the market - risk-free rate)

= 4 + 2.0833*(10 -4 ) = 16.499%

WACC for oil division= .6667*4 + .3334*16.499 = 8.1675%

IRR is more than WACC for oil division thus it is a good project since NPV at this WACC will be greater than 0 increasing shareholder's value.

IRR= 9.950% Year 0 1 2 3 Cash flow stream -237 120 100 60 Discounting factor 1 1.0995 1.208906 1.329195 Discounted cash flows project -237 109.14 82.71942 45.1401 NPV = Sum of discounted cash flows NPV A = -0.000222759 Discounting factor = (1 + IRR)^(CORRESPONDING PERIOD IN YEARS) Discounted Cashflow= Cash flow stream/discounting factor

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