Question

7. (30 points) Kirksville Inc. has 1,100 bonds outstanding that are selling for $992 each. The bonds carry a 6.0 percent coupon, pay interest semi-annually, and mature in 7.5 years. The company also has 9,500 shares of 5% preferred stock at a market price of $40 per share. This month, the company paid an annual dividend in the amount of $1.20 per share. The dividend growth rate is 5.0 percent. The common stock is priced at $30 a share and there are 34,500 shares outstanding. The company is considering a project that is equally as risky as the overall company. This project has initial costs of $630,000 and operating cash flows of $80,000 a year for the next 10 years and salvage value of $20,000 at the end of 10 years. The net working capital (NWC) is expected to increase by $10,000 a year until the end of the project life. All the NWCs will be recovered when the project is completed. The project will be depreciated straight-line to zero over the project's 10-year life. The tax rate is 21%. (a) (15 points) What is Kirksville's weighted average cost of capital? (b) (10 points) What is the net present value (NPV) of this project? Should you accept the project? Explain why. (c) (5 points) What is the internal rate of return (IRR) of this project? Should you accept the project if you apply the IRR decision rule?

Please provide detailed formulas and steps, I will give a positive rating, thanks!

Answer 1

a). WACC is the sum of the market value weighted costs of capital.

YTM for the bond: FV = 1,000; PV = 992; PMT = 6%*1,000/2 = 30; N = 7.5*2 = 15, CPT RATE.

Semi-annual YTM = 3.07%; Annual YTM = 3.07%*2 = 6.13%

	Market value (MV) (Number of bonds/shares*price)		Cost	Weight (W) (MV/Total MV)	W*Cost
Debt	10,91,200	YTM*(1-Tax rate)	4.85%	43.54%	2.11%
Preferred stock	3,80,000	Annual dividend/Current price	12.50%	15.16%	1.90%
Common stock	10,35,000	(D1/P0) + g	9.200%	41.30%	3.80%
Total	25,06,200			WACC	7.80%

WACC = 7.80%

b). Project NPV is calculated as follows:

Initial cost = 630,000

Free Cash Flows (FCF) from Year 1 to Year 10 = OCF - Increase in NWC = 80,000 - 10,000 = 70,000

PV of all FCFs: PMT = 70,000; N = 10; rate (WACC) = 7.80%, CPT PV.

PV = 473,869.45

After-tax salvage value = salvage value*(1-Tax rate) = 20,000*(1-21%) = 15,800 (There is no book value left at the end of the project)

PV of after-tax salvage value = 15,800/(1+7.80%)^10 = 7,452.06

Recovery of NWC at the end of the project = Total increase in NWC over project life = 10,000*10 = 100,000

PV of recovered NWC = 100,000/(1+7.80%)^10 = 47,164.91

Project NPV = - initial cost + PV of FCFs + PV of after-tax salvage value + PV of recovered NWC

= -630,000 + 473,869.45 + 7,452.06 + 47,164.91 = - 101,513.58

The project should not be accepted as it has a negative NPV.

c). IRR is calculated using the FCFs generated by the project over 10 years and the IRR function, as follows:

Formula	Year (n)	0	1	2	3	4	5	6	7	8	9	10
FCF10 = FCF + Recovered NWC + After-tax salvage value	FCFs	(6,30,000)	70,000	70,000	70,000	70,000	70,000	70,000	70,000	70,000	70,000	1,85,800
Using IRR function	IRR	4.46%

The project IRR is less than the WACC for the project so it should not be accepted as it will result in a loss.