Question

Chapter 9/10/11 , 2019 Based upon the following facts calculate the Weighted Average Cost of Capital (WACC) for Student Success Corporation (SSC): PART 1 – WACC  Tax rate = 40%  Debt Financing: $10,000 Face Value 10-Year, 5% Coupon, Semiannual Non-Callable Bonds Selling for $11,040 New bonds will be privately placed with no flotation cost.  Common Stock: Current Price $40; Current Dividend = $3.00 and Growth Rate = 5%.  Common Stock: Beta = 1.1; Risk Free Rate 2.0%; Required Return of the Market 7%  Capital structure: 40% Debt, 60% Common Equity 1) What is the cost of debt? 2) What is the cost of equity – use both CAPM and the Dividend Model? 3) What is the WACC – for Equity you can use either answer above or an average? PART 2 – Capital Budget If SSC is deciding upon whether to approve a capital project and the cash flows are as follows: Year 0 (initial investment) $2,000 Year 1 Cash Flow $1,000 Year 2 Cash Flow $600 Year 3 Cash Flow $400 Year 4 Cash Flow $4,000 Calculate: 1) Net Present Value (NPV) ____________________________ 2) Internal Rate of Return (IRR) ____________________________ 3) Payback Period ____________________________ Remember to use the WACC from above for the NPV and to compare to the IRR. Should this project be approved and why or why not?

Answer 1

1. Cost of Debt before tax calculated using Yield To Maturity Approach :-

1-(1+r) BondPrice = Semiannual Interest * - FaceValue +- + (1+r)

10000 11040 = 250 * ,1- (1+r) -20 - ) + (1 + r20

By solving the above equation, we get r = 1.8718%. Thus, Before Tax Cost of Debt is 3.7436% (1.8718*2)

After Tax Cost of Debt = 3.7436% * (1-0.4) = 2.2462%

2. Cost of Equity using CAPM Model = Risk Free Rate + Beta* Risk Premium

                                                           = 2 + 1.1* (7-2)

                                                            = 7.5%

Cost of Equity using Dividend Model = (Dividend/ Current Market Price) +Growth Rate

                                                          = (3/40) + 5%

                                                         = 12.5%

Cost of Equity using average of above two is 10% ((7.5+12.5)/2).

3. WACC if 40% Debt and 60% Equity = (2.2462*0.4)+(10*0.6) = 6.8985%.

Part 2

1. NPV Calculation :-

Year	Cash Flow	Discounting Factor @ 6.8985%	Present Value
0	(2,000.00)	1.0000	(2,000.00)
1	1,000.00	0.9355	935.47
2	600.00	0.8751	525.06
3	400.00	0.8186	327.45
4	4,000.00	0.7658	3,063.19
Total			2,851.16

2. IRR Calculation :-

Year	Cash Flow	Discounting Factor @ 45%	Present Value	Discounting Factor @ 46%	Present Value
0	(2,000.00)	1.0000	(2,000.00)	1	(2,000.00)
1	1,000.00	0.6897	689.66	0.684931507	684.93
2	600.00	0.4756	285.37	0.469131169	281.48
3	400.00	0.3280	131.21	0.321322719	128.53
4	4,000.00	0.2262	904.87	0.220084054	880.34
Total			11.11		(24.72)

By solving the above two rate, we get IRR as 45.31%.

3. Payback Period

Year	Cash Flow	Cumulative Cash Flows
0	(2,000.00)	(2,000.00)
1	1,000.00	(1,000.00)
2	600.00	(400.00)
3	400.00	-
4	4,000.00	4,000.00

Thus, the payback period is 3 years for the project.