1. Ember is considering an investment of $40 million in plant and machinery. Thi

Question

1. Ember is considering an investment of $40 million in plant and machinery. This is expected to produce free cash flows of $13 million in year 1, $14 million in year 2, $15 million in year 3, and 25 million in year 4. The tax rate is 35%. You dont know the target capital structure, but you do have the following information: Bonds: There are 37,000 bonds with a 5.5% coupon outstanding. The coupons are paid annually. The bonds have a 1000 face value and 8 years to maturity. They sell for 96.7% of par. Retained Earnings (Internal Equity): There are 950,000 shares outstanding with a price of $55 per share. The beta on the stock is 1.25. The risk-free rate is 2% and the market risk premium is 6%. a) Calculate the weighted average cost of capital. b) Calculate the net present value (NPV) with the WACC. c) Should they invest? Why or why not?

Explanation / Answer

cost of debt= 55/967= 5.688% After tax cost of debt= 5.688(1-.35)= 3.697% cost of equity= 2+1.25x6= 9.5% (a)WACC= (9.5x52250000/88029000) +(3.697x35779000/88029000)= 7.14% (b)NPV= -40 +13/1.0714+(14/1.0714^2)+(15/1.0714^3)+(25/1.0714^4)= 15.49928205million or $15499282.05

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