A firm is considering the purchase of an expensive piece of equipment. They plan

Question

A firm is considering the purchase of an expensive piece of equipment. They plan to use the Net Present Value method to determine whether or not to accept the project. They have the following information available:

            - The current capital structure for the company is 45% debt and 55% equity.

            - The YTM on the company’s outstanding bonds is 4.8%.

- Last year’s dividend was $1.20; the price of the company’s stock is currently $80, and the expected growth rate of the dividend is 3%.    

Management is trying to determine the appropriate required return to use in the NPV calculation. Which method would be most appropriate?

A) The IRR of the project is the required return.

B)The Weighted Average Cost of Capital should be calculated and used as the required return.

C) The 4.8% yield on the bonds is the required return.

D) The growth rate of 3% is the required return.

E) The dividend yield should be calculated and used as the required return.

Explanation / Answer

Price of the share=Dividend *(1+Growth rate)/(Expected return on Equity-Growth rate)

$80=$1.2*(1+3%)/(Expected return on Equity-3%)

Expected return on Equity-3%=$1.2*1.03/$80=$1.236/$80=0.01545=1.545%

Expected return on growth=1.545%+3%=4.545%=4.55%

The Weighted Average Cost of Capita=4.55%*0.55+4.8%*.45=4.6625%

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