Question

A project generates net (after-tax) cash flows of $20 million every year for 4 years. The investment is $48 million. The tax rate is 40%. The firm has a target debt ratio (debt ratio = debt/value) of 45%.

The firm’s current bonds have 5 years left to maturity, a coupon rate of 7% with annual coupons, a face value of $1000 and currently trade for $960. The (before-tax) cost on any new debt will be the same as the yield to maturity on the current bonds.

For the equity, they will use $6,000,000 in preferred stock and the rest will be from retained earnings. The preferred stock has a dividend of $4 with a price of $42. Issue costs on preferred stock are $2.

To estimate the cost of retained earnings, the firm expects to pay a dividend of $2.5 per share next year. The retention rate is 40% and the return on equity is 25%. The current stock price is $50.

Use the weighted average cost of capital (WACC) to find the net present value (NPV) of the project.

Answer 1

Answer on Question #42114, Economics, Finance

Cash flows of $20 million for 4 years.

Investment = $48 million.

Tax rate = 40%.

Debt ratio = 45%.

Bonds have 5 years left to maturity, a coupon rate = 7% annually coupons, face value = $1000, current price = $960.

$6,000,000 in preferred stock (dividend of $4 with a price of $42, issue cost = $2), the rest from retained earnings.

$2.5 per share next year, retention rate = 40%, return on equity = 25%. Current stock price = $50.

$$WACC = E/V * Re + D/V * Rd * (1-Tc)$$

Re = cost of equity

RD = cost of debt

E = market value of the firm's equity

D = market value of the firm's debt

V = E + D

E/V = percentage of financing, i.e., equity

D/V = percentage of financing, i.e. debt

TC = corporate tax rate

$$WACC = 0.45*0.25 + 0.45*0.4*(1-0.4) = 0.2205$$$$\begin{array}{l} NPV = 20000000/1.2205 + 20000000/1.2205^2 + 20000000/1.2205^3 + 20000000/1.2205^4 - 48000000 \\ = \$1826771,24 \end{array}$$