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.
