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Project Selection by calculating WACC

Given the following information for Bajor Co.:

Debt: Bajor's long-term debt capital consists of bonds with 8.250 percent coupon rate (semiannual coupon payments), 28 years time to maturity, and current price of 106.75 percent of its par value.

Preferred stock: Bajor has not issued any preferred stocks.

Common stock (equity):
§ Bajor's equity capital consists of common stocks with the most recent annual dividend of $1.20 per share, and a current stock price of $96 per share.

§ According to online data sources, Bajor's ROE is 15%, and dividend payout ratio is 45%, therefore its plowback (retention) ratio b = 1 - 45% = 55%, and the thus sustainable growth rate g = ROE * b / (1 - ROE * b) = 0.15*0.55 / (1 - 0.15*0.55) = 0.09, or g = 9%.

§ The "risk-free" Treasury bill return is 3.8 percent; the market expected return for large company stocks (similar to Bajor) on average is 12.3 percent; and Bajor's systematic risk (Beta) is 0.80.

Taxes: The applicable federal-plus-state corporate tax rate for Bajor is 40 percent.

Capital weight: Based on market values, Bajor's debt-equity ratio is 0.60. Use this debt-equity ratio to estimate the capital weights for equity and debt (We and Wd).

Time constraint: For any investment projects, Bajor wants to recover its initial cost within no more than 5 years.

1) Showing all work, what is Bajor's cost of debt? What is Bajor's cost of equity? What is Bajor's WACC? (Hint: For the cost of equity, please apply both CAPM and DGM and then average the estimates.)

2) There are three investment projects available to Bajor:
Project A costs $12 million today and then provides after-tax cash inflow of $3 million per year for the next 6 years.
Project B costs $18 million today and then provides after-tax cash inflow of $3 million per year for the next 8 years.
Project C costs $30 million today and then provides after-tax cash inflow of $4 million per year for the next 10 years.

If Projects A, B & C are mutually exclusive, which project(s) should Bajor accept?

3) If Projects A, B & C as described in 2) are independent, which project(s) should Bajor accept?

Solution Preview

1) Showing all work, what is Bajor's cost of debt? What is Bajor's cost of equity? What is Bajor's WACC? (Hint: For the cost of equity, please apply both CAPM and DGM and then average the estimates.)

The cost of debt is the Yield to Maturity (YTM) on the existing debt. The YTM is the current rate of return required by the investors and so we take YTM and not the coupon rate as the cost of debt. The YTM is the discounting rate that will make the present value of interest and principal equal to the price today. The interest amount is 1,000X8.250/2 = $41.25 every six months. The periods to maturity are 28X2=56 semi annual. The price is 1,000X106.75% = $1,067.50 and the par value is $1,000. We use a financial calculator or RATE function in excel to calculate the YTM. The YTM comes to ...

Solution Summary

The solution explains the calculation of cost of debt and equity and putting them together as WACC. Using the WACC to make project selection under independent projects and mutually exclusive projects

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