Question

The director for S Corp. manufacturers of playground equipment, is considering a plan to expand production facilities in order to meet an increase in demand. He estimates that this expansion will produce a rate of return of 11%. The firm’s target capital structure calls for a debt/equity ratio of .8 . S Corp has a bond issue outstanding for that will mature in 25 years and has a 7% annual coupon rate. The bonds are currently selling for $804. The firm has maintained a constant growth rate of 6%. S Corp’s next expected dividend is $2(D1) and it current stock price is $40. Its tax rate is 21%.
a. Should it undertake the expansion?
b. Calculate the Cost of bonds.
c. Calculate the Cost of equity.
d. Calculate the WACC

Answer 1

Answer:

a. The company should not undertake the expansion because the WACC is lower than the desired rate of return of the company

b. Cost of Bonds

Year   Cashflow    [email protected]%      PV           [email protected]%     PV

               $                                 $                                  $

  0        (804)           1              (804)           1                 (804)

1-25     55.3            9.0770    501.96    14.0939        779.39

25       1,000          0.0923      92.3      0.2953          295.3

                                  NPV      (209.74)              NPV    270.69                    

Kd = LR     + NPV1/NPV1+NPV2    x (HR – LR)

Kd = 5       + 270.69/270.69 + 209.74   x (10 – 5)

Kd = 5       + 270.69/480.43 x 5

Kd = 7.82%    

c. Ke = D1/Po   + g

  Ke = $2 /$40 + 0.06

  Ke = 0.05 + 0.06

 Ke = 0.11 = 11%

d.   WACC = Ke(E/V) + Kd(D/V)

     WACC = 11(100/180) + 7.82(80/180)

     WACC = 6.11 + 3.48

     WACC = 9.59%

   

Explanation:

FIrst and foremost, we need to calculate cost of bond using internal rate of return formula. The current market price of the bond will be considered in year o. The cash inflows for year 1 to year 25 is the after tax coupon which is calculated using the formula R(1 -T). The coupon is 7% of N1,000 par value, which is $70. Then we will subject it to tax ie $70(1-0.21) = $55.3. The cashflow for year 25 is the par value. Then, we will discount the cashflows in order to obtain cost of bond.

Cost of equity is equal to dividend in year 1 divided by the current market price plus growth rate.

WACC is the proportion of each stock in the capital structure multiplied by cost of each stock.

Market value of the company = 80 + 100 = 180 since debt-equity ratio is 0.8 (80/100). Debt is 80 while equity is 100.

Since WACC is 9.59% and the desired return of the company is 11%. Thus, we will not undertake the expansion.