Johnson Company’s stock price is $25 per share and it has 4 million shares outst
ID: 2811146 • Letter: J
Question
Johnson Company’s stock price is $25 per share and it has 4 million shares outstanding. Johnson Company has 70,000 10% annual coupon bonds with a par value of $1,000 each. The maturity of the bonds is 10 years and the YTM is 10.843%. The expected market return, rm, is 16% and Johnson’s stock beta, S, is 1.4. The risk-free rate of interest, rf, is 7% and the corporate tax rate, tc, is 34%.
1. Calculate the bond-to-stock ratio of Johnson Company.
2. Calculate the Johnson Company’s weighted average cost of capital, rwacc.
3. Johnson Company plans to invest $100 millions in a new soccer ball machine that produces an unlevered pre-tax cash flow of $25 million in perpetuity? The risk of the project is similar to Johnson's overall risk. Should Johnson Company invest in the new machine?
Explanation / Answer
Stock value = price* number of stocks
= 25*4,000,000 = $100,000,000
Bond value = Number of bonds * Par value
= 70000*$1000
= $70,000,000
1:Bond to Stock ratio = 70/100 = 0.7
2: After tax cost of debt = YTM*(1-Tax) = 10.843%*(1-0.34)
= 7.15638%
Cost of equity = Rf+Beta*(Rm-Rf)
= 7%+ 1.4*(16%-7%)
= 19.6%
Total value = Equity+ debt = 100,000,000+ 70,000,000
= $170,000,000
WACC= Cost of debt* Debt/ Total value + Cost of equity* Equity/Total value
= 7.15638%* 70/170 + 19.6%*100/170
= 14.47%
3: Pv of cash inflows = Cash flow/ WACC = 25/14.47%
= $172.6978
Net Present value of the project = $172.6978- 100 = $ 72.6978 million
Since the NPV is positive, the project should be undertaken.
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