1. WACC and NPV: Och, Inc.

, is considering a project that will result in initial after cash

savings of $3.5 million at the end of the first year, and these savings will grow at a rate of
5 percent per year indefinitely. The firm has a target debt-equity rate of .65, a cost of
equity of 15 percent, and an aftertax cost of debt 5.5 percent. The cost-saving proposal is
somewhat riskier than the usual projects the firm under takes; management uses the
subjective approach and applies an adjustment factor of +2 percent to the cost of capital
for such risky projects. Under what circumstances should Och take on the project?

Using the debt equity ration to calculate to WACC, we find :

RWACC=D/F*RD*(1-TC)+E/F*RE

RWACC =(.65/1.65)*(.055)+(1/1.65)*(.15)=0.091 or 9.11%

Adjusting our discount rate as a result of the higher risk :

Project discount rate= 9.11%+2%=11.11%

We will accept the project if the NPV is positive:

PV of future CF= 3,500,000/(.1111-.05)= $57,283,142

The project should be taken if it costs are less than $57,283,142 since costs less than
this amount will result in positive NPV.

2. Preferred Stock and WACC: The Saunders Investment Ban has the following financing
outstanding. What is the WACC for the company?

Debt: 40,000 bonds with a 7 percent coupon rate and a current price
quote of 119.80; the bonds have 25 years to maturity, 150,000 zero
coupon bonds with a price quote of 18.2 and 30 years until
maturity.
Preferred stock: 100,000 shares of 4 percent preferred stock with a current price of
$78, and a par value = $100.
Common stock: 1,800,000 shares of common stock; the current price is $65, and
the beta of the stock is 1.1.
Market: The corporate tax rate is 40 percent, the market risk premium is 7
percent, and the risk-free rate is 4 percent.

First finding the market value for each type of financing to get the market value of the firms
financing:
Let B1= the coupon bond, Let B2= the zero coupon bond, Let P= Preferred Stock
Let S= Common Stock, Let V= the firms Value,
Let Rs= cost of equity Let RP=cost of preferred stock
BB1=40,000($1000)(1.198)= $47,920,000
BB2=150,000($1000)(.182)= $27,300,000

P=100,000(78)= $7,800,000
S=1,800,000(65)= $117,000,000

The total value of the firm:

V= $47,920,000+$27,300,000+$7,800,000+$117,000,000= $200,020,000

Now we will find the cost of equity using CAPM model:

Rs= RF+B(MRP)
Rs=0.04+1.1(0.07)=0.117 or 11.7%

The cost of debt is the YTM of the bond so :

P0=$1,198=$35(PVIFAR%,50)+$1000(PVIFR%,50)
R=2.765%
YTM=2.765%*2=5.53%

The after tax cost of debt is:

RB1=(1-.40)(.0553)=0.0332 or 3.32%

The after tax cost of the zero coupon bond is:

P0= $182=$1000(PVIFR,60)
R=2.880%
YTM= 2.880%*2=5.76%
RB2=(1-.4)(.0576)=0.0346 or 3.46%

Finding preferred stock required return by using perpetuity equation:

Rp=D1/P0= $4/$78=0.0513 or 5.13%

Now we have all components needed to calculate WACC:

RWACC=(0.0332)*( 47,920,000/200,020,000)+( 0.0346)* (27,300,000/200,020,000)
+ (0.117)*( 117,000,000/200,020,000)+( 0.0513)*( 7,800,000/200,020,000)=8.31%

3. Flotation Costs and NPV: Photochronograph Corporation (PC) manufactures time series
photographic equipment. It is currently at its target debt-equity ratio of .70. Its considering
building a new $45 million manufacturing facility. This new plant is expected to generate
aftertax cash flows of $6.2 million a year in perpetuity. The company raises all equity from
outside financing. There are three financing options:
1. A new issue of common stock: The flotation costs of the new common stock would be 8
percent of the amount raised. The required return on the companys new equity is 14
percent.
 2. A new issue of 20-year bonds: The flotation costs of the new bonds would be 4 percent
of the proceeds. If the company issues these new bonds at an annual coupon rate of 8
percent, they will sell at par.
3. Increased use of accounts payable financing: Because this financing is part of the
companys ongoing daily business, it has no flotation costs, and the company assigns it a
cost that is the same as the overall firm WACC. Management has a target ratio of
accounts payable to long-term debt of .20. (Assume there is no difference between the
pretax and after-tax accounts payable cost.)
What is the NPV of the new plant? Assume that PC has a 35 percent tax rate.

D/E=.7
Initial cost 45mn
aftertax cash flows = $6.2 million a year in perpetuity
T= 35 percent tax rate
accounts payable to long-term debt of .20

We can use weight given for accounts payable to calculate the weight of accounts payable and
the weight of long term debt. The weight of each will be:

Accounts payable weight=

Long-term debt weight=