Question

Sundae Inc is deciding whether to undertake a new project. The project is expected to be riskier than the firm's current operations. For cost of capital estimation management wants to use the subjective approach and add 4 percent to its weighted average cost of capital of the firm The new project is expected to generate free cash flow of $900,000 by the end of the first year, and the cash flows are projected to grow at a rate of 3 percent per year thereafter It requires an initial investment of $9 million The current capital structure of the firm is as follows one-year annual-coupon bond with coupon rate of 2 percent, 100,000 Debt: shares outstanding, par value of $2,000, selling for 100 percent of par. 1,100,000 shares outstanding, selling for $90 per share on the Corunon stock: balance sheet the stockholders' equity is $6 million the beta 15 1.1. Market 5 percent market risk premium and 6 percent risk-free rate. The corporate tax rate is 21 percent. Answer the following questions The pre-tax cost of debt of the firm is 8. (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places (e.g. 32.16) - ) The cost of equity of the firm is 8. (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places (e.g., 32.16).) The debt/value ratio used in the calculation of the weighted average cost of capital of the firm is 8. The corresponding equity/value ratio is t. (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places (e.g. 32.16).)

Answer 1

a) Pre-tax cost of debt, rd = 2% as the bond trades at par value.

b) Using CAPM, Cost of equity, re = Rf + beta x MRP = 6% + 1.1 x 5% = 11.50%

c) Debt = 2,000 x 100,000 = 200 million, Equity = 1.1m x 90 = 99 million => Total Value = 299 million

% debt = 200 / 299 = 66.89% and % equity = 33.11%

d) WACC = wd x rd x (1 - tax) + we x re

= 66.89% x 2% x (1 - 21%) + 33.11% x 11.50%

= 4.86%

e) r = 4.86%

f) NPV = CF1 / (r - g) - CF0

= 0.9 / (4.86% - 3%) - 9

= $39,387,096.77