Question

SuperD Corporation is an electric power company in Hong Kong. In order to meet the rising demand for its electricity, the company is considering an investment in a new plant. The new project requires an initial outlay of $33 billion, and it will generate annual after-tax net cash flows of $246 million in perpetuity. As a manager of the Finance Department of the company, you were asked by your supervisor to compute the required return to be used when evaluating the new project. The corporate tax rate is 28%. You got the following pertinent information about the capital structure of the company.

– 39,000,000 shares of common stock with a book value of $4 per share and a beta of 1.3, currently trading at $128 per share.

– 4,300,000 units of 10-year zero-coupon bond with a par value of $1,000, currently trading at 78% of par.

– 31,000,000 shares of 8% preferred stock with a par value of $100, currently trading at $91 per share.

– The market risk premium is 8.6% and the risk-free rate is 3.2%. Required

a. Determine SuperD’s capital structure weights on a market value basis.

b.Compute the weighted average cost of capital (WACC) of SuperD Corporation.

c. Critically discuss how SuperD Corporation could use the WACC calculated in part (b) to determine the required return for the new project.

Answer 1

a]	Component of Capital Structure	Market Value [$ millions]	Capital Structure Weights
	Common stock [39*128]	$              4,992	27.14%
	Bonds [4.3*1000]	$              4,300	23.38%
	Preferred stock [91*100]	$              9,100	49.48%
	Total	$           18,392
b]	Cost common stock per CAPM = 3.2%+1.3*8.6% =	14.38%
	Before tax cost of debt [Zero coupon bond] = (1000/780)^(1/10)-1 =	2.52%
	After tax cost of debt = 2.52%*(1-28%) =	1.81%
	Cost of preferred stock = 8/91 =	8.79%
	Calculation of WACC:
	Component of Capital Structure	Market Value [$ millions]	Capital Structure Weights	Cost	WACC
	Common stock [39*128]	$              4,992	27.14%	14.38%	3.90%
	Bonds [4.3*1000]	$              4,300	23.38%	1.81%	0.42%
	Preferred stock [91*100]	$              9,100	49.48%	8.79%	4.35%
	Total	$           18,392			8.68%
c]	If the new project has the same risk as the existing projects, the WACC of 8.68% should be used as the
	discount rate.
	If the new project has risk different from the existing projects, the WACC should be adjusted to represent
	the true risk of the project. If the risk of the new project is higher, then the WACC should be adjusted
	upwards and vice-versa.