Question

1. The following balance sheet proportions belong to Shelbee Company. Shelbee can issue long-term bonds at current yield to maturity of 10%. It has just paid annual dividend of $2.00 per share and its dividends grow at a constant rate of 5%. Its shares trade at $25.00 per share. Shelbee’s marginal income tax rate is 20%.

	Book Value %	Market Value %	Target Capital Structure %
Assets	100	100	100
Liabilities	40	30	25
Equity	60	70	75

1. Calculate WACC for Shelbee.
2. Assume Shelbee can raise capital up to $800,000 at the costs calculated above (in a). If more capital is needed, it has to issue equity and face floatation costs of 20%. What would be the WACC with new equity issue?
3. Assume Shelbee has the following independent projects to evaluate.

Project	Cost $	IRR %
Green	300,000	14
Red	200,000	13
Orange	400,000	15
Purple	250,000	12

Which projects should it undertake and what is its capital budget?

Answer 1

a	Calculation of WACC
	For calculating target value rates are considered.
		Ratio	Cost	WACC
	Equity	0.75	13.40%	10.05
	Debt	0.25	8%	2
				12.05
	Kd = Post-tax yield to maturity
	= (10*0.80)		8
	Re = (D1/ Price)+g
		0.134	or 13.4%
	D1 =      2*1.05	2.1
	Price	25
b	New Price = 25 *0.80		20
	(After floatation cost)
	New Re	0.155	15.50%
		Ratio	Cost	WACC
	Equity	0.75	15.5	11.625
	Debt	0.25	8	2
				13.625
c	IRR means an internal rate of return from the project that the company
	will earn. Therefore the project with higher IRR should be undertaken provided
	that it should exceed WACC
	Project	Cost	IRR	Preference
	Green	300000	14	2
	Red	200000	13	3
	Orange	400000	15	1
	Purple	250000	12	4
	If the company has $800000 then it should invest in project orange and green.
	The further capital raised should not be invested in project Red because IRR is 13
	which is less than its cost i.e WACC
	Therefore raising of further capital beyond $ 800000should not be recommended