Question

HAPPY stock returns have a covariance with the market portfolio of 0.036. The standard deviation of the returns on the market portfolio is 20%, and the expected market risk premium is 7.5%. The company has bonds outstanding total market value of $35 million. The bond is 10% annual coupon with one-year maturity and sold each at 101.852% of the face value of $1000. The company also has 6 million shares of common stock outstanding, each selling for $20. The corporate tax rate is 35%, and Treasury bills currently yield 6%. The company is considering the purchase of additional equipment that would cost $45 million. The expected unlevered cash flows from the equipment are $13.5 million per year for five years. Purchasing the equipment will not change the risk level of the firm. Use the weighted average cost of capital (WACC) approach to determine whether HAPPY should purchase the equipment. (Hint: Use the CAPM with β=(covariance between the stock and the market portfolio)/(variance of market portfolio))

Answer 1

Beta = covar(Ri,Rm)/Var(Rm)
Beta =	.036/.2^2	0.90
Rf	6%
Rm-Rf	7.50%
Re=	12.7500%
Cost of debt
Yield	8.00%	RATE(1,10%*1000,-101.852%*1000,1000,,)
Tax rate	35%
Post tax cost of debt	5.20%
Capital structure	Value (mm)	Cost (post tax)
Stocks	120	12.7500%
Debt	35	5.20%
WACC		11.05%
NPV of investment
PV of inward cash flow @ WACC	$49.84	-PV(11.05%,5,13.5,,)
Less: initial investment	$45.00
NPV	$4.84
Since NPV is positive, we should go for the project