Please include at least 2 decimal spaces on all percentages.
Part 1
A firm has determined its optimal capital structure, which is composed of the following sources and target market value proportions:
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Target Market
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Source of Capital
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Proportions
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Long-term debt
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30%
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Preferred stock
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5%
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Common stock equity
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65%
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Debt: The firm can sell a 20-year, semi-annual,$1,000 par value, 9 percent bond for $980. A flotation cost of 2 percent of the face value would be required in addition to the discount of $20.
Preferred Stock: The firm has determined it can issue preferred stock at $65 per share par value. The stock will pay an $8.00 annual dividend. The cost of issuing and selling the stock is $3 per share.
Common Stock: The firm's common stock is currently selling for $40 per share. The dividend expected to be paid at the end of the coming year is $5.07. Its dividend payments have been growing at a constant rate for the last five years. Five years ago, the dividend was $3.45. It is expected that to sell, a new common stock issue must be underpriced at $1 per share and the firm must pay $1 per share in flotation costs. Additionally, the firm's marginal tax rate is 40 percent.
To help determine the firm's WACC, we will break this problem down into steps:
Calculate the rate for the new bond issue, notice is has semi-annual compounding.
Calculate the after-tax cost of the bond issue.
Calculate the cost of the new issue of preferred stock.
Calculate the growth rate of the common stock dividends.
Calculate the cost of the new common stock issue.
Finally, calculate the firm's weighted average cost of capital assuming the firm has exhausted all retained earnings.
Part 2
The same firm as in Part 1 is considering investment in two independent projects, X and Y, which are described below. Please don't assume anything. Use the firm's WACC which you just calculated to evaluate the projects.
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Project X
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Project Y
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Initial Investment
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$3,500,000
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$3,900,000
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Year
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Cash Inflows (CF)
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1
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$1,500,000
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$2,500,000
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2
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1,500,000
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1,800,000
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3
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1,500,000
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900,000
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4
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1,500,000
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850,000
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Calculate Payback Period for both projects
Calculate NPV for both projects
Calculate PI for both projects
Calculate IRR for both projects
Which project should the firm accept? Why?
Part 3
WACC problem using the CAPM
The current risk-free rate is 3% and the market is expected to return 7.5% per year. The company's beta is 2.0. The company expects to pay 6.0% for its debt. The target capital structure for the company is 60% equity and 40% debt. The marginal tax rate is 35%.
What is the after-tax cost of debt?
What is the cost of equity?
Calculate the WACC.
As with the other assignments, I will give you 5 bonus points on this assignment for setting it up in excel and for using excel to calculate your answers. However, to get the bonus, you must set it up in an organized manor. By this I mean that if I have to hunt for your answers because they are all over the place and are not marked, then you are not going to get the bonus.