3. Upsilon Ltd has the following ( independent ) investment opportunities; Outla

Question

3. Upsilon Ltd has the following ( independent ) investment opportunities;

   Outlay IRR

Project A $20,000,000 16%

Project B $20,000,000 15%

Project C $10,000,000 14%

Project D $10,000,000 13%

Project E $10,000,000 12%

The optimal capital structure calls for financing all projects with 60% ordinary equity and 40% dabt . The most recent dividend (D0) was $0.60. The growth rate of earnings and dividends is 6% per year . The most recent price of shares is $6. The company has bonds that were issued with a coupon rate of 11% and a yield to maturity of 13% . The company’s dividend payout ratio is 25% , and it is in a 36% tax bracket . Upsilon Ltd earned $20 million last year after taxes.

REQUIRED:

(a)Calculate Upsilon Ltd.’s WACC

(b)Which projects will Upsilon undertake ? Why?

(c)What will Upsilon’s total capital budget be?

(d)Answer in words only:

(1)If you were senior management of the firm and Upsilon had only $4,000,000 for projects , what would the optimal capital budget be ?

(2)If you were a divisional manager and all these projects , what would your response be?

Explanation / Answer

D1 = 0.60*(1+6%) = 0.636

Price = $6

Growth Rate = 6%

Let, cost of equity be k

So, 6 = 0.636/(k-.06)

=> Cost of Equity = 16.60%

Before tax cost of debt = 13%

After-tax cost of debt = 13% * (1-36%) = 8.32%

(a) WACC = (.6*16.60%) +(.4*8.32%) = 13.288%

(b) Upsilon should undertake Projects A, B and C as the IRR for these three projects is higher than WACC

(c) Total Capital budget = $20,000,000 + $20,000,000 + $10,000,000 = $50,000,000

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