Question

Here is a book balance sheet for Parker Associates. Figures are in millions. Assets Liabilities and Shareholders' Equity Assets (book value) $100 Debt $40 Equity $60 $100 $100 Unfortunately, the company has fallen on hard times. The 6 million shares are trading for only $s apiece, and the market value of its debt securities is 508 below the face (book) value. Suppose shareholders now demand a 258 expected rate of return. The bonds are now yielding 158. he a. What is weighted-average cost of capital if the firm's tax rate is 3417 b. If the company considers a normal project whose risk is about the same as the company's risk with an internal rate of return of 175, should it accept the project? Why or why not?

Answer 1

Qa:

WACC= (E/V)*ke + (D/V)*kd*(1-tax rate)

where E=market value of equity ; D=market value of debt ; V=E+D ; ke=cost of equity; kd=cost of debt

E=6*5 =30 million ; D =40*.5= 20 million ;V=30+20=50 million

WACC =(30/50)*25+ (20/50)*15*(1-.34) =18.96%

Qb:

No the company should not accept the project. As already the investors are demanding a required return of 18.96% and the new project has an IRR of only 17% which is lesser. So there wont be any benefit by going with the project.