Determine the WACC. Please provide step by step calculations. Thank you Determin

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Determine the WACC. Please provide step by step calculations. Thank you Determine the WACC. Please provide step by step calculations. Thank you Determine the WACC. Please provide step by step calculations. Thank you Case Assignment ou are the manager at K&B; Inc. You have been told that the company has an opportunity to Division Vice-President, ask you to evaluate the different opportunities and complete a report for expand into a new market, but will need to make a major investment to do it. Sara Harris, her including your recommendation on which expansions to do (using the methods discussed in Assume all the information given to you is accurate and all three expansions have the same risk. Options for capital structure (determine the WACC and choose the best capital structure for the the course for capital budgeting). The table below contains the information for each project. project) 35% debt at 10% with tax-rate of 40%; no preferred stock; 65% common stock at 15% or I. 50% debt at 11% with tax-rate of 40%; no preferred stock; 50% common stock at 15%. 2. Total available funds the company can raise for the expansion(s) is $10,000,000. The expansions cash flows are as follows: Expansion Initial Cost Year 1 Cash Flow Year 2 Cash Flow Year 3 Cash Flow Year 4 Cash Flow Year 5 Cash Flow Year 6 Cash Flow Year 7 Cash Flow Year 8 Cash Flow Year 9 Cash Flow 1,690,000 Florida 10,000,000 1,690,000 1,690,000 1,690,000 1,690,000 1,690,000 1,690,000 1,690,000 1.690,000 Alabama -10,000,000 0 0 725,000 800,000 900,000 2,000,000 3,000,000 4,000,000 5,000,000 6,000,000 ia -10,000,000 3,850,000 3,000,000 2,500,000 2,000,000 1,000,000 700,000 0 0 0 0 Year 10 Cash Flow 1,690,000 After your evaluation, write a memo (in word) to Sara Harris indicating your recommendation In the memo, you should indicate the rank of the projects, which projects are viable, then you should indicate which project(s) you recommend.

Explanation / Answer

Calculation of WACC for Capital structure 1:

Goven : Proportion od debt = 35%; Cost of debt = 10%; Cost of debt after tax = 10%(1-t) where t= tax rate = 10(1-0.40) = 6%, hence after tax cost of debt = 6%

Now, we can calculate the WACC by using the following formula

WACC = (W1 X Kd) + (W2 x Ke) where W1 = proportion of debt i.e 35%; W2 = Porportion of equity i.e 65%; Kd = after tad cost of debt i.e 6%; Ke = Cost of equity i.e 15%; Now, we can substiture the formula :

WACC = (35 x 6%) + (65 x 15%) = 2.1% + 9.75% = 11.85%

Calculation of WACC for Capital structure 2:

Goven : Proportion od debt = 50%; Cost of debt = 11%; Cost of debt after tax = 11%(1-t) where t= tax rate = 11(1-0.40) = 6.6%, hence after tax cost of debt = 6.6%

Now, we can calculate the WACC by using the following formula

WACC = (W1 X Kd) + (W2 x Ke) where W1 = proportion of debt i.e 50%; W2 = Porportion of equity i.e 50%; Kd = after tad cost of debt i.e 6.6%; Ke = Cost of equity i.e 15%; Now, we can substiture the formula :

WACC = (50 x 6.6%) + (50x 15%) = 3.3% + 7.5%% = 10.8%

Capital structure 2 ie. 50% debt and 50% common stock is the Best capital structure as its WACC is lower thant that of Capital structure 1 ie 35% debt and 65% common stock

By taking 10.8% as the cost of capital,we can evaluate three projects on the basis of NPV (Net present value)

NPV is the diferrence between the total present value of cash inflow and present value of cash outflow

NPV of Project 1= (-) 10,000,000 + 1,690,000 (PVA10.8%,10years)

= (-) 10,000,000 + (1,690,000 x 9.25925926)

= (-) 10,000,000 + 15,648,148 = $5,648,148

PVA = Present value of Annuity that can be calculated with the help of the following formula

PVA = A x (1+r)n -1/r(1+r)n where r = weighted average cost of capital i.e 10.8% or 0.108 ; n = no.of periods or years i.e 10 years ; A = annuity = $1; Substituting this formula

PVA = 1x (1+0.108)10 -1/0.108 (1+0.108)10 = 9.25925926

NPV of project 2 = (-) 10,000,000 + (3,850,000(PVF10.8%,1) + 3,000,000(PVF10.8%,2)+2,500,000 (PVF10.8%, 3) + 2,000,000(PVF10.8%, 4) + 1,000,000 (PVF10.8%, 5) + 700,000 (PVF10.8%, 6)   

NPV of project 2 = (-) 10,000,000 + (3,850,000 x 0.9025 + 3,000,000 x 0.8149 +2,500,000 x 0.7351+ 2,000,000 x 0.6635 + 1,000,000 x 0.5988 + 700,000 x 0.5404)

NPV of Project 2 = (-) 10,000,000 + 3,474,625 + 2,444,700 + 1,837,750 +1,327,000 + 598,800 + 378,280

NPV of Project 2 = (-) 10,000,000 + 10,061,155 = $61,155

Note: PVF = Present value factors for $1 can be calculated with the help of the followng formulas

Year 1 = 1/(1+r)1 = 1/(1+0.108)1 = 0.9025 where r = cost of capital i.e 10.8% or 0.108

Year 2 = 1/(1+r)2 = 1/(1+0.108)2 = 0.8149 etc.

NPV of project 3 = (-) 10,000,000 + (725,000(PVF10.8%, 3) + 800,000(PVF10.8%, 4) + 900,000(PVF10.8%, 5) + 2,000,000(PVF10.8%, 6) + 3,000,000(PVF10.8%, 7) + 4,000,000(PVF10.8%, 8) + 5,000,000(PVF10.8%, 9) + 6,000,000(PVF10.8%, 10)

NPV of project 3 = (-) 10,000,000 + (725,000x 0.7351 + 800,000 x 0.6635 + 900,000x 0.5988 + 2,000,000x0.5404 + 3,000,000x0.4877+ 4,000,000x 0.4402+ 5,000,000x0.3973 + 6,000,000 x 0.3586

NPV of Project 3 = (-) 10,000,000 + 532,947 + 530,800 + 538,920 + 1,080,800 + 1,463,100+1,760,800 + 1,986,500 + 2,151,600

NPV of project 3 = (-)10,000,000 + 10,045,467 = $ 45,467

Project NPV

1    $5,648,148

2 61,155

3 45,467

MEMO TO SARA HARIS:

Date:

Place:

To

Sara Harris

The vice President

K & B inc.

Sir/Madam

   Sub: Evaluation of project desirability on the basis of NPV

It is advised that Capital structure ie 50% debt and 50% common stock is preferable to the entity as it gives the lowest cost of raising funds ie. lowest WACC. By taking into this WACC, Net present value (NPV) of three projects have been calculated. The NPV of all three projects are as follows:

Project 1 : $5,648,148; Project 2 : $61,155; Project 3 : $45,467

Hence, it is recommended that project 1 is acceptable as its NPV is the greatest of all three; It gives the higest surplus to the comany

Thanking you

Yours sincerly

Sd/xxxxxxx

Manager

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