The risk free rate is 3%, measured by a long-term U.S. government bond. The tota

Question

The risk free rate is 3%, measured by a long-term U.S. government bond. The total market return is expected to be 11% over the foreseeable future. The Beta coefficient is 3.0 on the CAPM when finding out its hurdle rate for the project. The company expects to pay 5% for any new debt it receives, and its corporate tax rate is 40%.

To move forward, the company will expect to need $200 million in capital now, which they plan to finance through a combination of 30% debt and 70% equity infusions. The cash flows from this investment are expected to return $0 the first year, and then $70 million per year for the next 3 years, and then the project will be sold for $150 million

What is the weighted average cost of capital (WACC) to the firm for this project? (the

Explanation / Answer

Hi,

Please find the detailed answer as follows:

Part A:

Cost of Equity = Risk Free Rate + Beta*(Market Return - Risk Free Rate) = 3 + 3*(11-3) = 27%

WACC = Cost of Debt*(1-tax Rate)*Weight of Debt + Cost of Equity*Weight of Equity = 5*(1-.40)*30% + 27*70% = 19.80%

-------

Part B:

NPV = -200 + 70/(1+19.80%)^1 + 70/(1+19.80%)^2 + 70/(1+19.80%)^3 + 150/(1+19.80%)^3 = $35.16

-------

Part C:

NPV (10%) = -200 + 70/(1+10%)^1 + 70/(1+10%)^2 + 70/(1+10%)^3 + 150/(1+10%)^3 = $86.78

-------

Part D:

Minimum Investment (10%) = 70/(1+10%)^1 + 70/(1+10%)^2 + 70/(1+10%)^3 + 150/(1+10%)^3 = $286.78

Thanks.

Related Questions

Navigate

• Browse (All)
• Browse T
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.