Question

You try to evaluate an investment project for a company. A firm uses $38 million of debt and $15 million of preferred stock. The current market price of common stock is $20 with 4,125,000 shares outstanding, which it has used recently to finance in a number of its recent operating asset purchases. If the before-tax cost of debt is 8% and its cost of preferred stock is 10%. The risk free rate is assume to be 5%, while the market risk premium is 8%, with an above market level firm beta of 1.25 (slightly more volatile than the market). Assume the corporate tax rate for this firm is 35%.

a. Based on the information given, compute the WACC for the company.
b. If an investment project generates a return of 11% and has similar risk level as the overall company, would you accept this project? Why or why not?

Answer 1

a) total debt = $38 million

after tax cost of debt = 8% x (1 - 35%) = 5.2%

total preferred stocks = $15 million

cost of preferred stock = 10%

total common stocks = 4,125,000 x 20% = $82,500,000

Re = 5% + (1.25 x 8%) = 15%

weight of debt = 38 / 135.5 = 28.04%

weight of preferred stocks = 15 / 135.5 = 11.07%

weight of common stocks = 60.89%

WACC = (60.89% x 15%) + (11.07% x 10%) + (28.04% x 5.2%) = 11.7%

b) The project should be rejected because 11% is lower than the company's WACC (11.7%)