Question

4. DWY is a large publicly traded firm that is the market share leader in radar detection systems. The company is looking at setting up a manufacturing plant overseas to produce a new line of RDSs. The following market data on Hua Chuang's securities are current: Debt: 45,000 6.8 percent coupon bonds outstanding, 20 years to maturity, selling for 95 percent of par; the bonds have a $1000 par value each and make semiannual payments. Common stock: 750,000 shares outstanding, selling for $94 per share; the beta is 1.2. Preferred stock: 35,000 shares of 6.2 percent preferred stock outstanding, selling for $92 per share. Market: 8 percent expected market risk premium; 5.20 percent risk-free rate. DEI's tax rate is 34 percent. The new RDS project is somewhat riskier than a typical project for Hua Chuang, primarily because the plant is being located overseas. Management has told you to use an adjustment factor of +2 percent to account for this increased riskiness. Calculate the appropriate discount rate to use when evaluating Hua Chuang's project. (20 marks)

Please do not use Excel to solve this question.

Answer 1

To calculate the appropriate discount rate, we will calculate the weighted-average cost of capital first, using the above information

Cost of debt after the tax impact ( interest on debt saves the company taxes) is K_d (1-t), where K_d is the yield-to-maturity or YTM of the debt.

To find out the YTM of the company's debt, we need to feed the following data into a financial calculator. n = 20years *2 = 40 (since semiannual payments are made), present value of the bond= 95% *$1000 = $950, PMT or payment = -(0.068/2*$1000) = $34, and FV= $1000 I/Y=3.64% Since coupons are given semiannually, yield-to-maturity = 3.64%*2 = 7.28%

Hence K_d= 7.28%, and after-tax cost of debt = 0.0728 * (1-0.34) = 0.048 or 4.80%

Next, we find out the cost of preferred shares which is Dividends on preferred shares/market price of the preferred share = (0.062*100)/92 = 6.2/92 = 6.74%

Now, we have to calculate the cost of equity, using the CAPM approach.

According to the CAPM the cost of equity = risk-free rate of return + Beta of stock (risk premium) = 5.2% + (1.2*8%) = 14.8%

The next step is to find out the weightage of debt, preferred shares and common shares. For that, we have to find out the total capital of the company, with the information above, using the market price of each source of capital and the outstanding amount. Total capital (45,000* $950) +(35,000 * $92) + (750,000 * $94) = $42,750,000 + $3,220,000 + $70,500,000 = $116,470,000

Now, we will find out the weights on debt, preferred shares and common equity, to find out the weighted-average cost of capital or WACC.

The weight of debt = the value of outstanding debt/ total capital = (45,000*$950)/$116,470,000 = 0.3670 = 36.70%

Similarly, the weight of preferred shares can be found out as follows, (35,000 * $92)/$116,470,000 = 0.02765 or 2.765%

and finally the weight of equity = (750,000 * $94)/$116,470,000 0.6053 or 60.53%

Now that we have calculated the company's cost and weight of debt, preferred shares and common shares, we can calculate the WACC using the following formula

WACC = (Weight of debt * after-tax cost of debt) + (weight of preferred shares * cost of preferred shares) + ( weight of common equity * cost of common equity)

= (0.3670* 0.0480) + ( 0.02765 * 0.0674) + (0.6053* 0.148) = 0.0176 + 0.00186 + 0.08958 = 0.10904 or 10.904%

Adding the 2% adjustment factor due to increased risk, the appropriate discount rate for evaluating the project = 10.904% + 2% = 12.904%