08%20cost%20of%20capital%20-%20lecture%20problems%20solutions

# 08%20cost%20of%20capital%20-%20lecture%20problems%20solutions

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Unformatted text preview: Lecture problems – cost of capital What is the WACC for Snuggly Baby Corp. if the tax rate is 25% and the firm has 5,000,000 shares of common equity priced at \$15 each with an expected return of 20%; 1,000,000 shares of preferred equity priced at \$35 each with an expected return of 16%; and 80,000 bonds that mature in 5 years, are priced at \$1,125 each, and have a yield-to-maturity of 12%? WACC = [(E/V) × R E ] + [(P/V) × R P ] + [(D/V) × R D × (1 – Tc)] E = 5,000,000 shares × \$15 = \$75 million P = 1,000,000 shares × \$35 = \$35 million D = 80,000 bonds × \$1,125 = \$90 million V = E + P + D 1 + D 2 = \$75 million + \$35 million + \$90 million = \$200 million R E = .20 R P = .16 R D = .12 Tc = 0.25 Note that with the information that’s given, the time-to-maturity is not relevant WACC = [(75m/200m) × .20] + [(35m/200m) × .16] + [(90m/200m) × .12 × (1 – 0.25)] = .0750 + .0280 + .0405 = .1435 = 14.35% 1 Lecture problems – cost of capital Part A: Should Wawanakwa Corporation, which has a WACC of 8.6% and makes frozen food for grocery stores, undertake a project to open a restaurant if the restaurant project is considered by all to be as risky as the average-risk project at Wawanakwa and the restaurant project would involve an investment of \$2 million today, an expected cash flow of \$200,000 in one year, and subsequent cash flows that would continue forever and increase by 0.6 percent every year? NPV = C + [C 1 / (1+r) 1 ] + [C 2 / (1+r) 2 ] + [C 3 / (1+r) 3 ] + … C = -\$2,000,000 C 1 , C 2 , C 3 , … make up a growing perpetuity where C 1 = \$200,000 and g = .006 The present value of C 1 , C 2 , C 3 , … = C 1 / (r – g) r = Wawanakwa’s WACC = .086, since the project has the same level of risk as an average-risk project for Wawanakwa NPV = -2,000,000 + 200,000/(1.086) 1 + (200,000×1.006)/(1.086) 2 + (200,000×1.006 2 )/(1.086) 3 + ... = -2,000,000 + present value of a growing perpetuity where C 1 =200,000, g=.006, and r=.086 = -2,000,000 + [200,000 / (.086 – .006)] = -2,000,000 + [200,000 / .080] = -2,000,000 + 2,500,000 = 500,000 NPV > 0, so Wawanakwa should pursue the project 2 Lecture problems – cost of capital Part B: Should Mario Incorporated, which has a WACC of 17.0 percent, pursue the same restaurant project that Wawanakwa is considering in part A?...
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## This note was uploaded on 02/03/2011 for the course FINANCE 301 taught by Professor Murray during the Spring '09 term at George Mason.

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08%20cost%20of%20capital%20-%20lecture%20problems%20solutions

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