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Weighted Average Cost of Capital and Net Present Value

Ember is considering an investment of $40 million in plant and machinery. This is expected to produce free cash flows of $13 million in year 1, $14 million in year 2, $15 million in year 3, and 25 million in year 4. The tax rate is 35%. You don't know the target capital structure, but you do have the following information:
- Bonds: There are 37,000 bonds with a 5.5% coupon outstanding. The coupons are paid annually. The bonds have a 1000 face value and 8 years to maturity. They sell for 96.7% of par.
- Retained Earnings (Internal Equity): There are 950,000 shares outstanding with a price of $55 per share. The beta on the stock is 1.25. The risk-free rate is 2% and the market risk premium is 6%.
a) Calculate the weighted average cost of capital. Hint: To get the weights, you will need to solve for the market value of the debt and equity.
b) Calculate the net present value (NPV) with the WACC.
c) Should they invest? Why or why not?

Solution Preview

Dear Student:

A1a. Ember's WACC (Weighted Average Cost of Capital) is calculated as follows:

Step 1. Find the formula to be used. Note that the company has no preferred stock, so we can omit that part.

WACC = sum of (cost of debt + cost of equity)
WACC = wd*kd*(1-T) + wc*kc
Where wd = weight of debt, wc = weight of common stock (equity), kd = cost of debt, kc = cost of common stock, and T = tax rate.

Step 2. Identify the variables.

kd = calculate yield to maturity
kc = use ...

Solution Summary

This solution shows a step-by-step explanation, how to calculate WACC, cost of equity using CAPM, capital structure weights, and a NPV with an initial investment and a 4-year cash inflows. A decision of investment will be made based on calculations.