You have the following information about Constance Security, a lock manufacturer
ID: 2374741 • Letter: Y
Question
You have the following information about Constance Security, a lock manufacturer:
Equity Shares Outstanding
10 million
Stock price per share
$20.00
Yield to maturity on debt
8.00%
Book value of interest-bearing debt
$135 million
Coupon interest rate on debt
6.00%
Market value of debt
$130 million
Book value of equity
$80 million
Cost of equity capital
12%
Tax rate
40%
Constance is contemplating an average-risk investment costing $15 million that promises an annual after-tax cash flow of $2 million in perpetuity. a. What is the internal rate of return on the investment? Hint: Use the perpetuity equation from Chapter 7's DCF discussion. b. What is Constance%u2019s weighted average cost of capital? c. If undertaken, would you expect this investment to benefit shareholders? Why or Why not?
Equity Shares Outstanding
10 million
Stock price per share
$20.00
Yield to maturity on debt
8.00%
Book value of interest-bearing debt
$135 million
Coupon interest rate on debt
6.00%
Market value of debt
$130 million
Book value of equity
$80 million
Cost of equity capital
12%
Tax rate
40%
Explanation / Answer
(a) Rate of return on investment = 2/15=13.33%. (b) Cost of equity=12%. Book value of equity=$80mn. After tax cost of debt=yield*(1-tax rate)=8%*(1-40%)=4.8%. Book value of debt=$135mn. WACC=12%*80/(80+135)+4.8%*135/(80+135)=6.06% As the rate of return on the investment is greater than the WACC, the firm should undertake the investment. This will also benefit the shareholders as it is greater than the cost of equity also.
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