Question

Q2. What is the EAC of two projects: project A, which costs $150 and is expected to last two years, and project B, which costs $190 and is expected to last three years? The cost of capital is 12%. (1 mark)

Answer:

Q3. A company pays annual dividends of $10.40 with no possibility of it changing in the next several years. If the firm’s stock is currently selling at $80, what is the required rate of return? (1 mark)

Answer:

Q4. Stag corp has a capital structure which is based on 50% common stock, 20% preferred stock and 30% debt. The cost of common stock is 14%, the cost of preferred stock is 8% and the pre-tax cost of debt is 10%. The firm's tax rate is 40%. (1 mark)

1. Calculate the WACC of the firm.
2. The firm is considering a project that is equally as risky as the firm's current operations. This project has initial costs of $280,000 and annual cash inflows of $66,000, $320,000, and $133,000 over the next three years, respectively. What is the net present value of this project ?

Answer 1

Q 1:

EAC of Project A= $88.75

EAC of Project B= $79.11

Calculation as below:

Ap 190 te А в C D E 1 Equivalent Annual Cost (EAC) 5 Cost of capital (R) 12% 6 Project 7 Cost $ 150.00 8 Annual Maint Cost AMC 9 Discount rate (R/100) r= 12% 10 No. of years 2 11 12 EAC= (Asset Price/Annuity Factor)+ Annual Maintenance Cost 13 Annuity Factor (AF)= {1-[1/(1+r)^t}/r 14 Option 16 I Formula Cell reference Value Cell reference 17 1+r= 1+D9 1.12 1+F9 18 (1+r)^t= D19^D10 1.2544 F19AF10 19 1/(1+r)^t 1/D18 0.79719388 1/F18 20 1-{1/(1+r)^t} 1-D19 0.20280612 1-F19 21 Annuity Factor 1-{1/(1+r)^t}/r D20/09 1.69005102 F20/F9 22 23 EAC (AP/AF)+AMC (07/021)+D8 $ 88.75 (F7/F21)+F8 15 Value 1.12 1.404928 0.71178025 0.28821975 2.40183127 $ 79.11 20

Q 3:

As per Dividend Discount Model, Current Price P0= D1/r-g

Where D1= next year dividend, r= rate of return and g= growth rate.

Given that P0= $80, g=Nil

Current Dividend= $10.40. With no growth, D1= $10.40

Substituting the values,

$80= $10.40/r.

Therefore, Rate of return r = $10.40/$80 = 0.13 =13%

Q 4:

WACC= We*Re + Wp*Rp + Wd*Rd*(1-T)

Where We= Weight of Equity (given as 50%),

Re= Cost of equity (14%),

Wp= Weight of Preferred stock (20%),

Rp= Cost of Preferred stock (8%),

Wd= Weight of debt (30%)

Rd= Pre tax cost of debt (10%) and

T =Tax rate (40%)

Substituting the values,

WACC= 0.50*0.14 + 0.2*0.08 + 0.3*0.1*(1-0.4) = 0.07+0.016+0.018 = 0.104= 10.40%

Net Present Value of the project= $ 141,175.15 as follows:

F10 c =F9-E5 B C D E 1 WACC 10.4% Year Disc rate PV Factor Amounts in $ (t) () (PVF) Cash Flow PV 1/(1+r)^t (CF) (CF*PVF) 5 Initial Investment 1.000000 $ 280,000 $ 280,000.00 6 Cash flows 1 10.4% 0.905797 $ 66,000 $ 59,782.61 7 Cash flows 2 10.4% 0.820468 $ 320,000 $ 262,549.88 8 Cash flows 3 10.4% 0.743178 $ 133,000 $ 98,842.66 9 Sum of PVs SUM(C6:08) $ 421,175.15 10 NPV = Sum of PVs - Initial investment $ 141,175.15 11