Dave Inc. recently hired you as a consultant to handle project valuation. You ha
ID: 2726264 • Letter: D
Question
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
Part A
Cost of equity:
Ke = Rf +MRP x beta
= 0.03 + 0.10 x 1.40
= 17%
Do = 1
D1 = 1 x (1+0.30) = 1.30
D2 = 1.30 x (1+0.30) = 1.69
Price at the end of year 2:
P2 = D2 x (1+g) / (R- g)
= 1.69 x (1+0.05)/ (0.17 -0.05)
= 1.7745/ 0.12
= 14.79
Current price would be present value of future dividend and future prices:
Year
CF
PV factor 17%
PV
1
1.3
0.8547
1.11
2
1.69
0.7305
1.23
2
14.79
0.7305
10.80
13.15
So current price would be 13.15.
Part B
After tax cost of debt = 3% x (1-0.35)
= 1.95%
Source
Amount
Cost
Cost x amount
Debt
20000000
1.95%
390000
Equity
26300000
17.00%
4471000
Total
46300000
4861000
WACC = sum of cost of amount x cost / sum of amount
= 10.50%
Part c)
Year
CF
PV factor 17%
PV
0
-7000000
1.0000
-7000000.00
1
0
0.8547
0.00
2
0
0.7305
0.00
3
1500000
0.6244
936555.83
4
1500000
0.5337
800475.07
5
1500000
0.4561
684166.73
6
1500000
0.3898
584757.89
7
1500000
0.3332
499793.07
8
1500000
0.2848
427173.56
NPV
-3067077.85
Since, NPV of the project is negative (-3067077.85), this project should not be undertaken.
Year
CF
PV factor 17%
PV
1
1.3
0.8547
1.11
2
1.69
0.7305
1.23
2
14.79
0.7305
10.80
13.15
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