Part A. Assume the cost of equity, preferred stock and debt of JPM Inc are 20%,
ID: 2621199 • Letter: P
Question
Part A. Assume the cost of equity, preferred stock and debt of JPM Inc are 20%, 15% and 12%, respectively. Their capital structure is 40% equity, 20% preferred stock and 40% debt. What is the weighted cost of capital (WACC) if the tax rate is 40%?
a. 16.16%
b. 14.42%
c. 15.88%
d. 13.88%
Part B. JPM Inc proposes to borrow $10 million capital to expand their operations, $4 million in bonds and the rest in common stock. They can issue stocks for $43.75 by paying a dividend of $3.50 next year and maintain a growth rate of 8%. They can issue 20-year bonds for $699.07 paying 8% coupon, paid semi-annually. What is the weighted cost of capital assuming a tax rate of 35%.
a. 11.16%
b. 12.72%
c. 14.40%
d. 16%
Part C. JPM Inc is planning to invest $1,000,000 in new equipment that will increase its after-tax cash flows by $300,000 for the next five year. Its capital structure is 50% debt and 50% equity. If the cost of equity is 18% and after-tax cost of debt is 8%, should they undertake the project?
a. No, NPV = -$61,848.69
b. No, NPV = -$17,711.90
c. Yes, NPV = $29,924.29
d. Yes, NPV = $55,169.33
a. 16.16%
b. 14.42%
c. 15.88%
d. 13.88%
Explanation / Answer
A) WACC = Portion of debt*Cost of debt*(1-Tax rate) + Portion of preferred stock*Cost of preferred stock + Portion of equity*Cost of equity
= 0.4*12%*(1-0.4) + 0.2*15% + 0.4*20%
= 13.88%
Ans: 13.88%
B) Price of stock = Dividend next year/(Cost of equity - Growth rate)
43.75 = 3.5/(Cost of equity - 0.08)
Cost of equity - 0.08 = 3.5/43.75 = 0.08
Cost of equity = 0.08 + 0.08 = 16%
Calculating cost of debt:
NUmber of periods = 20 * 2 = 40 (because this is a semi-annual bond)
PMT (Payment per period) = 8%/2 * 1000 = $40
PV = $699.07
FV = $1000
Using Rate function in excel:
YTM =RATE(40,40,-699.07,1000)*2 = 12%
Therefore, cost of debt = 12%
WACC = Portion of debt*Cost of debt*(1-Tax rate) + Portion of preferred stock*Cost of preferred stock + Portion of equity*Cost of equity
WACC = (4/10)*12%*(1-0.35) + 0*0 + (6/10)*16% = 12.72%
Ans: 12.72%
C)
WACC = Portion of debt*Cost of debt*(1-Tax rate) + Portion of preferred stock*Cost of preferred stock + Portion of equity*Cost of equity
Here after-tax cost of debt is given
WACC = 0.5*8% + 0*0 + 0.5*18% = 13%
NPV = -$1,000,000 + $300,000/1.13 + $300,000/1.132 + $300,000/1.133 + $300,000/1.134 + $300,000/1.135
= $55,169.33
Ans: d. Yes, NPV = $55,169.33