Market Value Capital Structure value Bonds, coupon=8% paid annually $20 million
ID: 2649554 • Letter: M
Question
Market Value Capital Structure value
Bonds, coupon=8% paid annually $20 million
($1000 par value, remaining maturity=10 years)
Preferred stocks $3 million
Common stocks $35 million
Total value $58 million
The bonds current price is $935.82. The preferred stocks are selling for $12 per share and the common stocks for $10 per share. The preferred stock pays $1 dividend per share. The common stocks beta is 1.2, the market risk premium is 8%, and the risk-free rate is 3%. The firms average tax rate is 40%.
a) Find the firms WACC.
b) Suppose that the firm is considering a project that is expected to generate $1 million per year for 5 years. If this project has the same risk as the firm has, how much is the firm willing to pay for this project?
Explanation / Answer
a. Cost of Debt(Kd) = Interest x (1 - tax rate)/Bond price = 80 x (1 - 0.4)/935.82 = 5.13%
Interest = 1,000 x 8% = $80
Cost pf preference shares(Kp) = dividend / preferred stock price = 1/12 = 8.33%
Cost of Equity(Ke) = Rf + (Risk premium x Beta) = 3 + (8 x 1.2) = 12.6%
WACC = [(20 x 5.13%) + (3 x 8.33%) + (35 x 12.6%)] / 58 = 9.80%
b. Since the risk of the project is same as of the firm thus WACC of the project will also be 9.80% and all the cash flows will be discounted at this rate.
The firm should pay = Cash Flows x PVAF(9.8%, 5years) = 100,000 x 3.810 = $381,000
Thus, the maximum firm should pay for the project is $381,000
Note: The value of PVAF is taken from the PVAF table.