Question

What is Odarian's weighted average cost of capital?

Use the NPV function in Excel to find the project's NPV? Should Odarian open the coffee s
hop? Explain.

3. Consider the following information for Odarian, Inc. Odarian's target capital structure is 38% long-term debt, 15% preferred stock and 67% equity. The firm has one outstanding 8.03% bond issue that matures on November 7, 2039 makes semiannual payments, and currently sells for $851 per bond. Assume that November 7, 2019, is the settlement date for the bond issue. • Odarian's preferred stock pays an annual dividend of $2.37 and currently sells for $1.29 o The company's common stock's returns have a covariance of 0.00359824709 with the market's returns. The variance of the market's returns is 0.001883899. The market risk premium is 11.48 percent, and the risk free rate of return is 1.87 percent . The company's marginal tax rate is 22%. a. What is Odarian's weighted average cost of capital? b. Odarian operates coffee shops nationwide and plans to open a shop in Oregon. The table below contains the cash flow analysis for this expansion. Year 0 1 2 3 4 Cash Flow -$3,500,000 $1,000,000 $2,000,000 $1,400,000 $1,000,000 Use the NPVO function in Excel to find the project's NPV? Should Odarian open the coffee shop? Explain.

Answer 1

The solution to part a)

Calculation of Cost of Bonds (K_d)

= [ Coupon Payments (1-tax) + (Maturity Value - Bond Price)/remaining life of the bond ] / [(Maturity Value + Bond Price) / 2]

= [ $ 80.3*(1-22%) + ($ 1000 - $ 851)/20] / [ ($ 1000 + $ 851)/2]

= ($ 62.63 + $ 7.45)/$ 925.50

= 7.57%

Cost of Preferred Stock (K_p)

= [Dividend / Market Price ] * 100

= ($ 2.37 / $ 27.25)*100

= 8.70%

Cost of Equity (K_e)

= Risk-Free Return + (Market risk premium)*Beta

where

Beta = [Coveriance with market returns / variance of market returns]

= 0.00359824709 / 0.001883899

= 1.91

hence,

K_e = 1.87% + 11.48%*1.91

= 23.80%

Hence,

The weighted average cost of capital (WACC) of the company will be calculated as:

	Cost OF Capital	Target Weight	WACC
Long Term Debt	7.57%	38%	2.88%
Preferred Stock	8.70%	15%	1.31%
Equity	23.80%	47%	11.19%
TOTAL		100%	15.37%

Hence, Odarian's weighted average cost of capital is 15.37%

The solution to part b)

Calculation of NPV using excel function:

Year	0	1	2	3	4
Cash Flows	$ (3,500,000.00)	$ 1,000,000.00	$ 2,000,000.00	$ 1,400,000.00	$ 1,000,000.00
WACC	15.37%
NPV	=NPV(rate,value1,value2,….)
NPV	$299,495.28

Hence, the NPV of the project is $ 299,495.28

In order to decide whether Odarian should open the coffee shop or not, we will calculate the IRR of the project.

Year	0	1	2	3	4
Cash Flows	$        (3,500,000.00)	$ 1,000,000.00	$ 2,000,000.00	$ 1,400,000.00	$ 1,000,000.00
WACC	15.37%
IRR	=IRR(values,guess)
IRR	20%

As the IRR of the project is higher than its WACC, thus, Odarian should open the coffee shop.