The company evaluates all projects using both payback and NPV, their internal cr
ID: 1175912 • Letter: T
Question
The company evaluates all projects using both payback and NPV, their internal criteria relating to payback allows for a maximum of 3 years. the hurdle rate to be used with NPV is cost of capital plus 5% Given the above should they proceed under both methods.I'm having a hard time figuring out what I need to add the 5% to calculate NPV correctly. At first I thought that I would add the 5% to the bond market rate (9%) is this correct?
Company XYZ is considering an investment opportunity in '11. The financials associated with this project for year 1 are: Sales 350,000 Expenses (Ex Dep) 265,000 Sales & Expenses are expected to increase by 1% per year - after year 1 Fixed Asset (Investment) associated with this project are expected to cost 150,000 Fixed Assets will be depreciated via the 5 year MACRS. The project will be evaluated over 3 years. They intend to finance the project similar to the way they have historically financed projects. Pertinent data is as follows: Existing Capital Structure Bonds 50,000 P/S 150,000 C/S 300,000 Bond Market rate '10 7.0% Bond Market rate '11 (projected) 9.0% Company believes they could issue Preferred Stock at a price of $31.00 The dividend associated with this would be $2.50 Flotation costs would be 3% of the sales price Company also believes they could issue Common Stock at a price of $39.00 Flotation costs would be 2% of the sales price Dividend will be based on historic growth. Dividend History is as follows: Dividend History Year Dividend 2008 2.00 2009 2.07 2010 2.16 Company is in the 40% tax bracket The company evaluates all projects using both Payback & NPV. Their internal criteria relating to Payback allows for a maximum of 3 years. The hurdle rate to be used with NPV is Cost of Capital plus 5%. Given the above - should they proceed under both methods. BONUS - What is the maximum hurdle rate that is acceptable - show/prove your answer.Explanation / Answer
No, you don't add 9% to 5% to get hurdle rate. Read carefully, they are asking you to add 5% to the Cost of Capital. Now, capital for the project is to be raised using three sources :
1) Debt (For this cost of capital is after tax bond market rate)
2) Preference stock
3) Common stock
We have to compute the weighted average cost of capital, multiplying the individual cost of capital of the three sources with their respective weights in the capital and adding them.
Cost of Debt
Pre tax cost of debt = 9% (We use expected rate because capital is yet to be raised)
Post tax cost of debt (kd) = Pre tax cost x (1 - tax rate) = 9% x (1 - 0.40) = 5.40%
Cost of Preferred stock
Cost of Preferred stock (kp) = Preferred Dividend / (Stock price - Flotation cost)
or, Cost of preferred stock (kp) = $2.50 / ($31 - $31 x 3%) = 0.08313934153 or 8.313934153%
Cost of common stock
Common stock cost (ke )using constant dividend growth model -
ke = [ D1 / (P0 - F) ] + g
where, D1 = expected dividend, P0 = common stock price, F = flotation cost, g = growth rate
We have all the info except growth rate.
We computed average growth rate as the growth rate of previous two years was not equal.
D1 = D0 x (1 + g) = $2.16 x (1 + 0.03923913043) = $2.24475652172
ke = [ $2.24475652172 / ($39 - $39 x 2%) ] + 0.03923913043 = 0.09797164015 or 9.797164015%
Weighted Average cost of capital (WACC)
Weight of debt (D) = Debt / Total capital = $50,000 / $500,000 = 0.10
Weight of Preferred stock (P) = $150,000 / $500,000 = 0.30
Weight of Common stock (E) = $300,000 / $500,000 = 0.60
WACC = kd x D + kp x P + ke x E = 5.4% x 0.10 + 8.313934153% x 0.30 + 9.797164015% x 0.60 = 8.9124786549% or 8.91%
Hurdle Rate = WACC + 5% = 8.91% + 5% = 13.91%
This is the rate you use for computation of NPV.
Let me know in case you need any further help.
Growth rate Year Dividend Growth rate 2008 $2 - 2009 $2.07 ($2.07 - $2) / $2 = 0.035 2010 (D0) $2.16 ($2.16 - $2.07) / $2.07 = 0.04347826086 Average growth (g) (0.035 + 0.04347826086) / 2 = 0.03923913043 or 3.923913043%