As a financial analyst for National Engineering, you are required to estimate th
ID: 2732866 • Letter: A
Question
As a financial analyst for National Engineering, you are required to estimate the cost of capital the firm should use in evaluating its heavy construction projects. The firm’s balance sheet data and other information are listed below. Assume a 35% corporate tax rate.
a. What is your estimate? What assumptions must you make to calculate this estimate?
b. What qualifications to this estimate should you mention in your report when National applies this rate to its various projects?
Selected Balance Sheet Items
Bonds (see market data)
Preferred stock $ 400,000
Common Stock $ 800,000
Retained Earnings $2,000,000
Market Data
Market Value Yield
Bonds:
8%, 10-year $ 250,000 12%
12%, 15-year $1,000,000 15%
21%, 1-year $ 250,000 11%
Common stock:
Average dividend growth (5 years) = 10%
Current Dividend Yield = 7%
Price = $47.25
Shares = 100,000
Preferred stock:
$4.50 preferred dividend
Price = $22.50
Shares = 20,000
Explanation / Answer
a.Total value of bonds (market Value)= 250,000 + 1,000,000 + 250,000 = 1,500,000
Total value of common equity (maket value) = 47.25 * 100,000 = 4,725,000
Total value of preferred stock (market value) = 22.50* 20,000 = 450,000
Total value = 1,500,000 + 4,725,000 + 450,000 = 6,675,000
Weight of bonds = 1,500,000/6,675,000 = 0.2247
Weight of equity = 4,725,000/6,675,000 = 0.7079
Weight of preferred stock = 1-0.2247 - 0.7079 = 0.0674
Cost of bonds (after tax) = 12*(1-0.35)* 250/1500+ 15*(1-0.35)* 1000/1500 + 11*(1-0.35)*250/1500 = 8.99 = 9%
Cost of equity by DCF:
D0 = 7% of 47.25 = 3.3075
D1 = 3.3075*1.10 = 3.63825
g = 10% = 0.1
P0 = 47.25
Ke = Cost of equity = D1/P0 + g = 3.63825/47.25 + 0.10 = 0.177 = 17.7%
Cost of preferres shares = 4.50/22.50 = 20%
Cost of capital for the firm (WACC)= 0.2247 * 9% = 0.7079*17.7% + 0.0674*20% = 15.90%
The estimate for cost of capital is 15.90%. The assumption here is to use market value weights as against the book value weights are these are more relevant
b. This is only the general cost of capital applicable to the firm based on its weights. If the heavy construction prohect also uses the debt, equity and preferred capital in the same manner as that of the firm, we can use this cost of capital. If it uses only debt or only equity or uses different sources of capital, then this is not applicable to the project
Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.