Note: Not using excel. Please show all steps. Dave Inc. recently hired you as a

Question

Note: Not using excel. Please show all steps.

Dave Inc. recently hired you as a consultant to handle project valuation. You have obtained the following information. The firm has 2 million shares of common stock outstanding. The common stock just paid a dividend of $1. It is expected to grow by 30% per year for the next 2 years. After that, the dividend is expected to grow at a constant rate of 5% per year forever. The market value of debt is $20 million. The current risk-free rate is 3% and the market premium is 10%. The company’s equity beta is 1.4 and the corporate tax rate is 35%.

a. What is Dave’s current stock price per share?

b. What is the company’s WACC?

c. Suppose you have a project that’s going to cost $7 million initially, and it will generate cash flow of $1.5 million every year for 6 years, starting from year 3. Assume the project is as risky as the firm, will you take it?

Explanation / Answer

a)Cost of Equity=Ke=3+1.4*10=17%

Stock price=1*1.3/(1.17)+1*(1.3^2)/1.17+1*(1.3^2)*(1.05)/((0.17-0.05)*(1.17^2))=13.36

b)Market value of Equity=Me=13.36*2 million=26.72 million

Debt Value=D=20 Million

hence Weight of equity in firm=We=26.72/(26.72+20)=0.57

and Weight of debt=Wd=1-0.57=0.43

therefore Wacc=We*Ke+Wd*Kd*(1-tax)=0.57*17+0.43*3*(1-0.35)=10.53%

c)NPV of project= -7+1.5/(1.1053^3)+1.5/(1.1053^4)+1.5/(1.1053^5)+1.5/(1.1053^6)=(-3.15) since the NPV of the firm is negative i'll not take the project.

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