For a publically traded firm, assume CFFA = $100,000,000 for 2017. The firm’s an
ID: 2655955 • Letter: F
Question
For a publically traded firm, assume CFFA = $100,000,000 for 2017. The firm’s annual growth rate in its CFFAs is 4%. The company employs three major capital components (equity, debt, and preferred stock) to finance itself. The company is targeting a distribution in the three capital components of Ws= 40%, Wd= 55%, Wps= 5%. Last period’s dividend was $4.00 and is growing at a constant rate of 3.5%. Simultaneously, in the stock market, the E(Rm) = 8%, Rf=3%, pfirm,M =.37 and qm=.35, Po=$35. The preferred stock for firm has a dividend of $12.00 and it is trading at $120. In thousand dollar units, firms with comparable risk have outstanding 10-year, 10% coupon debt (compounded annually) that is trading at $790. LMNO sees 10-year debt as their preferable timeframe for a debt issue. Finally, the firm marginal tax rate is 30%. First, find the firm’s WACC? Second, the firm is thinking about taking on a project which will require a $10,000,000 investment. The expected cash flows from this project to the firm are:
Period
Net Flow to Firm in Dollars
1
$1,000,000
2
$2,000,000
2
$2,500,000
4
$3,000,000
5
-$2,000,000
6
$3,000,000
7
$2,000,000
Should the firm take on this project? Teach the concept(s).
Period
Net Flow to Firm in Dollars
1
$1,000,000
2
$2,000,000
2
$2,500,000
4
$3,000,000
5
-$2,000,000
6
$3,000,000
7
$2,000,000
Explanation / Answer
we first find the cost of debt using the bond data for the comparable firm. For this, we calculate the yield to maturity of the firm as shown below.
PV = cashflow / ((1 + ytm)^period) ; bond price = sum of PVs
cash flow is the coupon payment while ytm is the discount rate for the PVs.
now cost of debt = 14.0%
cost of preferred stock (PS) = dividend / value of PS = 12 / 120 =10%
Now, for cost of equity, we use the gordon growth model formula:
P0 = Dividend * (1 + growth rate) / (cost of equity - growth rate)
therefore, cost of equity = [ (4 * 1.035) / 35 ] + 0.035 = 15.33%
Now, WACC = (1 - tax rate) * cost of debt * Wd + Ws * cost of equity + Wps * Cost of PS
= (1-0.3)* 0.14 * 0.55 + 0.1533 * 0.4 + 0.1*0.05 = 12.02%
For second part, we calculate the NPV of the project using WACC as the discount rate.
Since the project has negative NPV, it should not be undertaken.
YTM 14.0% Coupon rate 10% Period 1 2 3 4 5 6 7 8 9 10 Cash flow 100 100 100 100 100 100 100 100 100 1100 PV 87.7 76.9 67.4 59.1 51.9 45.5 39.9 35.0 30.7 295.9 Bond price 790.0Related Questions
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