Question

PLEASE DETAIL THE ANSWERS

Assume that BF, Inc., has 10,000 bonds outstanding, paying a 5.6 percent coupon rate semi- annually and with a par value of $1,000 per bond. They all mature in 25 years and currently sell for 97 percent of par. Their current yield to maturity is 6.4%. The firm’s marginal tax rate is 35%.

The company also has 435,000 shares outstanding, currently selling for $61 per share. The stock beta of the company is currently estimated at 1.02. The current expected return to the market is 12 percent, and the current risk-free rate is 5.75 percent.

The firm is broken into three divisions: Textiles, Accessories, and Miscellaneous. The average Textiles project has a beta of 0.7; the average Accessories project has a beta of 1.3; and the average Miscellaneous project has a beta of 1.1.

The firm is currently considering the projects shown in the table below. The current approach isto use the firm’s WACC to evaluate all projects, but management sees the wisdom in adopting asubjective divisional cost of capital approach. Firm management is thus considering a divisionalcost of capital scheme in which they will use the firm’s WACC for Miscellaneous projects, the firm’s WACC minus 1 percent for Textiles projects, and the firm’s WACC plus 3 percent forAccessories projects.

Projects	Division	Expected return of each project	Beta of each project
A	Accessories	17%	1.3
B	Accessories	15%	1.2
C	Miscellaneous	13%	1.3
D	Miscellaneous	11%	0.7
E	Textiles	9%	0.8
F	Textiles	7%	0.5

Business Finance I

1) Compute the current weighted average cost of capital of the firm (WACC).

2) Which projects would be accepted/rejected if the company uses its cost of capital (WACC) as the hurdle rate? (hurdle rate means minimum required rate of return for accepting a project).

3) Which projects would be accepted/rejected if the company uses the subjective approach? (In this approach, as you can read in the text, the company adjusts its cost of capital to get specific hurdle rates for each division).

4) Would switching to an objective divisional cost of capital approach, where the WACC foreach division is based on that division’s average beta, improve they are accept/reject criteria any further? What would be the projects to accept under this objective approach?

5) Calculate the required rate of return on equity for each project using the specific beta of each project. Compute the specific WACC to each project and deduce the projects that actually should be accepted/rejected?

Note: When computing the WACC of a new project or of a specific division, you only have to compute the new cost of equity (using the new beta). All the rest (weight of equity, weight of debt, cost of debt, tax rate) remain unchanged in the WACC formula.

Answer 1

Answer 1:

Bond:

Market value = 10,000 * $1,000 * 97% = $9,700,000

Current yield to maturity is = 6.4%

Marginal tax rate is = 35%

Equity:

Market value = 435,000 * $61 = $26,535,000

Cost of equity = Risk free rate + Beta * (Market rate of return - Risk free rate) = 5.75% +1.02 * (12% - 5.75%) = 12.125%

Total capital= Market value of bond +Market value of equity = $9,700,000 + $26,535,000 = $36,235,000

WACC = Cost of equity * Equity proportion + Pretax cost of bond * (1 - Tax rate) * Bond proportion

= 12.125% * $26,535,000 / $36,235,000 + 6.4% * (1- 35%) * $9,700,000 / $36,235,000

= 9.99%

WACC =9.99%

Answer 2:

Proiects Division Accepted / Rejected A Accessories В Accessories C Miscellaneous D Miscellaneous F Textiles F Textiles Expected return of each project 17.00% 15.00% 13.00% 11.00% 9.00% 7.00% Firm's WACC 9.99% 9.99% 9.99% 9.99% 9.99% 9.99% Accepted Accepted Accepted Accepted ejected ejected

Answer 3:

WACC for Miscellaneous projects = WACC of the firm = 9.99%

WACC for Textiles projects = the firm’s WACC minus 1 percent = 9.99% - 1% = 8.99%

WACC for Accessories projects = The firm’s WACC plus 3 percent = 9.99% + 3% = 12.99%

Answer 4:

Although using WACC for each division based on that division’s average beta is an objective and appropriate approach, the results in terms Acceptance/Rejection of projects remains as found with subjective approach. Details are as below.

Objective approach:

Textile division:

The average Textiles project has a beta of 0.7

Cost of equity = 5.75% + 0.7* (12% - 5.75%) = 10.125%

WACC = 10.125% * $26,535,000 / $36,235,000 + 6.4% * (1- 35%) * $9,700,000 / $36,235,000 = 8.53%

Accessories:

Average Accessories project has a beta of 1.3

Cost of equity = 5.75% + 1.3 * (12% - 5.75%) = 13.875%

WACC = 13.875% * $26,535,000 / $36,235,000 + 6.4% * (1- 35%) * $9,700,000 / $36,235,000 = 11.27%

Miscellaneous

the average Miscellaneous project has a beta of 1.1

Cost of equity = 5.75% + 1.1 * (12% - 5.75%) = 12.625%

WACC = 12.625% * $26,535,000 / $36,235,000 + 6.4% * (1- 35%) * $9,700,000 / $36,235,000 = 10.36%

Answer 5:

The answers are already done in answer 4 above.