XYZ Company has $2,000,000 of long-term debt outstanding. The bonds were issued

Question

XYZ Company has $2,000,000 of long-term debt outstanding. The bonds were issued at par and the price per bond is $990 with 10 years left to maturity. The bonds have a yield to maturity of 7 percent. The company has 23,760 shares of common stock outstanding with a book value of $2,500,000. The current market price of the stock is $125 per share. XYZ has a beta of 1.2, while 10 year Treasuries are yielding 4 percent and the market risk premium is 6 percent. XYZ's tax rate is 40 percent. What is XYZ's WACC? XYZ is contemplating a five year project with an initial cost of $500,000 and the following cash flows: Should XYZ invest in the project?

Explanation / Answer

Part I :-

Cost of equity =4% + 1.2( 6%)

= 4% + 7.2%

= 11.2%

Cost of debt = Interest (1 - tax) + 1/maturity ( realisable value - net proceed) / 1/2( realisable value + net proceed)

= (7% * $1000)(1-0.40) + 1/10($1000 - $990) / 1/2 ($1000 + $990)

= $70 (0.60) + 1/10 *$10 / $995

=( 42 + 1) / 995

= 43/995

= 4.32%

WACC (Book Value)

Book value Weightage Cost WACC

Equity $2500000 0.56 11.2% 6.27%

Debt $2000000 0.44 4.32% 1.90%

   $4500000   8.17%   

WACC (Market Value)

Market value Weightage Cost WACC

Equity 2970000 0.6 11.2% 6.72%

Debt $1980000 0.4 4.32% 1.73%

   $4950000 8.45%

Note:- Market value of equity = (23760 share *$125)

= $2970000

Market value of debt = $2000000 * $1000 * $990

   = $1980000

Part II:-

We assume that WACC of market value is considered ;

Year cash flow PVF(8.45%, nyears) present value

1 225000 0.922 207450   

2 150000 0.850 127500

3 100000 0.784 78400

4 75000 0.723 54225

5 50000 0.667 33350

$500925

Net present value = $500925 - $500000

= $925

Yes, XYZ should invest in this project , because this project NPV is positive

Note:- PVF(8.45% , n years):-

1 year = 1 / (1+0.0845) = 0.922

   2 year = 1 / (1+0.0845)2  = 1 / 1.176 = 0.850

   3 year = 1 / (1+0.0845)3 = 1 / 1.276 = 0.784

4 year = 1 / (1+0.0845)4 = 1 / 1.383 = 0.723

5 year = 1 / (1+0.0845)5 = 1 / 1.500 = 0.667

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