Question

DragonFlights, Inc. is planning on purchasing a new flying dragon for their new route to Volantis. The cost of the dragon is $10.3 million. On average the dragons are operational for about 10 years. Dragon will be retired after 10 years with no salvage value. Marketing department of DragonFlights has conducted consumer surveys and market research in order to determine market demand and estimate future sales. This research has cost them $100,000. Based on the results of market studies management of the company estimates that they can make 150 flights per year on the new route the 1st year of operations. Each flight will generate sales of $55,000 per flight. Revenues are expected to decline 2% per year as the dragon gets older and doesn't have the energy to make as many flights per year. Annual maintenance of the dragon will cost the company $150,000. Salary of the dragon pilot is $250,000 per year. Variable costs per flight are $15,000. Feeding the dragon will cost the company $450,000 per year. Other fixed costs per year are $1.25 million. Tax rate is 25%. DragonFlights has reset criteria for approving capital projects. Payback period has to be four years or less, NPV has to be positive and IRR has to beat the hurdle rate. DragonFlights uses their cost of capital as hurdle rate. DragonFlights is currently financed with common equity and debt in the form of bonds. They have 1 million shares outstanding and shares are trading at a price of $116 per share. Stock beta is 2.8 as dragon flying business is a risky business. Company is also financed with publicly traded bonds in the total amount of $50 million in book value with 50 thousand bonds outstanding. Bonds are trading at premium at for $1,250 per bond. Bonds have 20 years to maturity and have a coupon rate of 14%, with coupon paid semi-annually. Bonds have a face value of $1,000. Current risk-free rate is 2.5% and market risk premium is 7%. Marginal tax rate is 25%.

Answer 1

Answer : Calculation of WACC

: (a.) Calculation of Firm's After tax cost of Debt :

Using Financial Calculator

=RATE(nper,pmt,pv,fv)

where nper is Number of years to maturity i.e 20 * 2 = 40 (As coupons are paid semiannually therefore multiplied by 2)

pmt is Interest payment i.e 1000 * 14% = 140 / 2 = 70 (Divided by 2 As coupons are paid semiannually)

pv is Current Market Price

= 1250

Note : pv should be taken as negative.

fv is face value i.e 1000

=RATE(40,70,-1250,1000)

therefore , Cost of Debt is 5.45184%(Semiannual)

Before Tax Cost of Debt is 5.45184% * 2 = 10.90367%(Annual)

After Tax Cost of Debt = 10.90367% * (1 - 0.25) = 8.18%

(b.) Cost of Equity = Risk Free rate + (Beta * Market Risk Premium)

= 2.5% + (2.8 * 7%)

= 22.1%

(c.) Calculation of WACC :

Market Value of Equity = Number of shares * Market Price per share

=1 million * 116

= 116 million

Market Value of Debt = Number of Bonds * Market Price

= 50000 * 1250

= 62,500,000 or 62.5 million

Total Market Value = 116 million + 62.5 million

= 178.5 million

Weight of Equity = 116 / 178.5

= 0.64985994397 or 0.6499

Weight of Debt = 62.5 / 178.5

= 0.35014005602 or 0.3501

WACC = (Cost of after tax Debt * Weight of Debt) + (Cost of Equity * Weight of Equity)

= [ 8.18% * 0.3501] +[22.1% * 0.6499]

= 2.8634% + 14.3619%

=17.23%

Depreciation per year using SLM = Cost / Number of year of useful Life

= 10.3 million / 10

= 1.03 million