JCC Holdings Limited is a large company in Hong Kong. The company’s operations c

Question

JCC Holdings Limited is a large company in Hong Kong. The company’s operations comprise four core businesses: retail, infrastructure, energy and telecommunications. In order
to meet the rising demand for its data services, the telecommunications operation is considering an investment in a new plant. The new project requires an initial outlay of $219
million, and it will generate annual after-tax net cash flows of $23 million in perpetuity. As a manager of the Finance Department of the company, you were asked by your supervisor to compute the appropriate discount rate to be used when evaluating the new project. You got the following pertinent information about the capital structure of the company.

- 4,800,000 units of 8-year zero-coupon bonds with par value of $1,000, currently trading at 60% of par.
- 15,000,000 shares of 15% preferred stock with par value of $100, currently trading at $210 per share.
- 22,000,000 shares of common stock with par value of $1 and beta of 0.8, currently trading at $75 per share.
- The market risk premium is 8.3% and the risk-free rate is 1.8%.

Required:
a. Compute JCC’s capital structure weights on a market value basis. (10 marks)
b. Suppose the corporate tax rate is 16%, determine the weighted average cost of capital (WACC) of JCC Holdings Limited. (15 marks)
c. Critically discuss why JCC Holdings Limited should not use the WACC calculated in part (b) as the required return for the new project. (15 marks)
d. JCC Holdings Limited adopts a subjective approach to adjust the cost of capital and has decided to use an adjustment factor of +3% for the new project. Calculate the NPV for the new project and make recommendation whether the company should accept it or not. (10 marks)

Explanation / Answer

Market Value of equity = No. of shares x Share Price = 22 x 75 = 1,650 million

Market Value of debt = No. of bonds x Market price = 4.8 x 1000 x 60% = 2,880 million

Market Value of P.S. = 15 x 210 = 3,150 million

Total Value = 7,680

Capital Structure: Equity = 1650 / 7680 = 21.48%, Debt = 2880 / 7680 = 37.50%, Pref. Stock = 3150 / 7680 = 41.02%

b) Using CAPM, Cost of equity, ke = Rf + beta x MRP = 1.8% + 0.8 x 8.3% = 8.44%

Cost of debt, kd = (100 / 60)^(1/8) - 1 = 6.59%

Cost of preferred debt = 15 / 210 = 7.14%

WACC = wd x kd x (1 - tax) + wps x kps + we x ke = 6.82%

c) JCC Holdings has multiple businesses and the WACC calculated reflects the diversified risk and not the risk of the telecom project. Hence, we should not used the above WACC.

d) NPV = -CF0 + CF1 / r

Here, CF0 = 219, CF1 = 23, r = 6.82% + 3% = 9.82%

=> NPV = -219 + 23 / 9.82% = $15.22 million

JCC Value Weight Cost WA Equity 1650 21.48% 8.44% 1.813% Debt 2880 37.50% 6.59% 2.077% P.S. 3150 41.02% 7.14% 2.930% 7680 WACC 6.820%

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