ASSIGNMENT Q 2.docx - Question 2 a Expected Cash Flows...

Question 2
a) Expected Cash Flows each Year = Weighted Average of the three possible states of the economy.
Probability : Good Economy = 30% / Poor Economy = 20% / Average Economy = (100-(30+20)) = 50%
Expected Cash Flows:
Year 1 = (350,000 x .3) + (200,000 x .5) + (180,000 x .2) = 240,000
Year 2 = (300,000 x .3) + (275,000 x .5) + (225,000 x .2) = 272,500
Year 3 = (400,000 x .3) + (325,000 x .5) + (270,000 x .2) = 336,500
Year 4 = (320,000 x .3) + (275,000 x .5) + (250,000 x .2) = 283,500
Year 5 = (250,000 x .3) + (175,000 x .5) + (150,000 x .2) = 192,500
b) Discount Rate = Weighted Average Cost of Capital
The weighted average cost of capital is the rate that a company is expected to pay on average to all
its security holders to finance its assets. The WACC is commonly referred to as the firm's cost of
capital.
WACC =
❑
i = 1
N
r
i
. MV
i
❑
i = 1
N
MV
i
 WACC = weighted average cost of capital
 N = number of sources of capital (securities, types of liabilities)

r
i
= required rate of return for security

❑
i
= security

MV
i
= market value of all outstanding securities
In order to find Weighted Average cost of capital, we must find the return on equity (cost of equity)
for the funding sources.
i. Interest rate of loan =
48,000 x 5
200000
– 1 = 0.2 = 20%
ii. YTM = (
FV
P
¿¿
1
n
– 1 =(
400,000
250,000
¿¿