The Patrick Company issued bonds today at par value of dollar 1000. The coupon p

Question

The Patrick Company issued bonds today at par value of dollar 1000. The coupon payment was set at dollar 120 with payments to be made annually. The company plans to issue new stock at 5 percentage flotation cost, it paid a dividend of dollar 2 last year and expects to pay dollar 2.12 this year. It currently trades at dollar 14.00 per share, and its stock is expected to grow at 6 percentage in the future. If there are 5000 shares outstanding, 60 bonds outstanding, and the company faces 25 percentage tax, what is the WACC? Patrick Company is evaluating these mutually exclusive projects below. Which projects would you pick under the NPV, IRR, and MIRR for each project? For every project accepted or rejected under each method, give a reason. Use the Patrick Company WACC calculated above rounded to 2 decimal places.

Explanation / Answer

Solution 1:

Total Debt = 60 bonds x $1,000 = $60,000
Total Equity = 5,000 Shares x $14 = $70,000

Total Capital = $60,000 + $70,000 = $130,000

Weight of Debt in capital = $60,000/$130,000 = 0.4615
Weight of Equity in capital = $70,000/$130,000 = 0.5385

Cost of debt will be after-tax coupon rate:
=> ($120/$1,000) x (1-tax rate)
=> 0.12 x 0.75 = 0.09 or 9%

Cost of equity will be required rate of return:
=> Current Price = Expected Dividend / (Required rate of return – Growth rate)
=> $14 = $2.12/(Ke – 0.06)
=> Ke = 0.2114 or 21.14%

WACC = (0.09 x 0.4615) + (0.2114 x 0.5385) = 0.155374 or 15.54%

Solution 2:

NPV of Project A = -$6,000 + ($2,000/1.1554) + ($300/1.15542) + ($400/1.15543) + ($700/1.15544) + ($1,325/1.15545) + ($700/1.15546) + ($700/1.15547) = -$2,199.72

NPV of Project B = -$5,500 + (-$800/1.1554) + ($725/1.15542) + ($32/1.15543) + (-$325/1.15544) + ($35/1.15545) + ($1,600/1.15546) + ($725/1.15547) = -$4,857.62   

IRR of Project A:
0 = -$6,000 + ($2,000/IRR) + ($300/IRR2) + ($400/IRR3) + ($700/IRR4) + ($1,325/IRR5) + ($700/IRR6) + ($700/IRR7) = 0.57%

IRR of Project B:
0 = -$5,500 + (-$800/IRR) + ($725/IRR2) + ($32/IRR3) + (-$325/IRR4) + ($35/IRR5) + ($1,600/IRR6) + ($725/IRR7) = -13.72%

MIRR(reinvestment approach) of Project A:

In the reinvestment approach, we find the future value of all cash except the initial cash flow at the end of the project using the reinvestment rate. So, the reinvesting the cash flows to time 5, we find:

Time 7 cash flow = $2,000(1.1554)7 + $300(1.1554)6 + $400(1.1554)5 + $700(1.1554)4 + $1,325(1.1554)3 + $700(1.1554)2 + $700(1.1554) = $12,069.09

So, the MIRR using the reinvestment approach:

0 = -$6,000 + [($12,069.09) / (1+MIRR)7]
$6,000 = [($12,069.09) / (1+MIRR)7]
(1+MIRR)7 = $12,069.09 / $6,000
(1+MIRR)7 = 2.0115

MIRR = (2.0115)1/7 – 1 = 0.1050 or 10.50%

MIRR (reinvestment approach) of Project B:
Time 7 cash flow = -$800 + $725(1.1554)6 + $32(1.1554)5 - $325 + 35(1.1554)3 + $1,600(1.1554)2 + $725(1.1554) = $3,693.23

So, the MIRR using the reinvestment approach:

0 = -$5,500 + [($3,693.23) / (1+MIRR)7]
$5,500 = [($3,693.23) / (1+MIRR)7]
(1+MIRR)7 = $3,693.23 / $5,500
(1+MIRR)7 = 0.6714964

MIRR = (0.6714964)1/7 – 1 = -0.0553 or -5.53%

No projects should be selected as NPV for both projects are negative. IRR & MIRR, both are lower than the required rate of return (WACC).

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