Financial Management Unit VIII Assignment

1. The Turnip Company plans to issue preferred stock. Currently, the company’s stock sells for $110. Once new stock is issued, the Turnip Company would receive only $90. The dividend rate is 8%, and the par value of the stock is $100. Compute the cost of capital of the stock to your firm. Show all work: Financial Management Unit VIII Assignment.

Cost of capital for preferred stock = Dividends rate/Net issuance proceeds

Stock price = $110

Issuance proceeds = $90

Dividend rate = 8%

Par value for stock = $100

Dividend payment per share = 8% × $100 = $8

Cost of Capital = ($8/$90) × 100 = 8.89%

2. The Maximus Corporation is considering a new investment, which would be financed from debt. Maximus could sell new $1,000 par value bonds at a new price of $920. The bonds would mature in 13 years, and the coupon interest rate is 10%. Compute the after-tax cost of capital to Maximus for bonds, assuming a 34% tax rate. Show work.

Face value of Bond (Fv) = $1000

Maturity(n) = 13

Interest rate = 10%

Therefore, the annual interest (int) will be = $1000×10% = 100

Current price (CP) = 920

So, YTM = Int + FV-CP/n/ Fv + CP/2

= 100 +( 1000-920)/13/ [(1000+920)/2]

= 100 + 6.154/960

= 0.1106 = 11.06%

Therefore, the after-tax cost of debt = 11.06(1-0.34)

=7.390%

3. Connor Corporation is considering two projects (see below). For your analysis, assume these projects are mutually exclusive with a required rate of return of 10%.

	Project 1	Project 2
Initial investment	$(465,000)	$(700,000)
Cash inflow Year 1	$510,000	$850,000

Compute the following for each project:

• NPV (net present value)

NPV = Σ (Cash inflow / (1+i) n) – Initial Investment

Project 1

($510,000/ (1+0.1) n)-$465,000

= ($1,359)

Project 2

($850,000/ (1+0.1) n)-$700,000

= $72,735

• PI (profitability index)

PI = Present value of future cash flows/initial investments

Project 1

PI=510,000/465,000 = 1.096

Project 2

PI=850,000/700,000 = 1.214

• IRR (internal rate of return)

IRR of Project 1:

PV rate at 5% = 485,714.29

Required PV = $465,000

PV at 10% = 463,636.36

Difference 485,714.29 – 465,000 = 20,714.29

463,636.36 -465,000 = -1,363.64

Therefore, IRR of Project 1= 5% + (10% -5%) × (20,714.29/ (20,714.29+1,363.64))

= 9.69%

IRR Project 2:

PV rate at 10% = 772727.27

Required PV = $700,000

PV at 25% = 680,000

Difference 772,727.27 – 700,000 = 72,727.27

680,000 – 700,000 = -20,000

Therefore, IRR of project 2 = 10% + (25%- 10%) × (72,727.27/ (72,727.27 +20,000)

= 21.76%

Based on your analysis, answer the following questions:

• Which is the best choice? Why?

Project 2 is the best choice for investment. Notably, this is so because it has a positive NPV, which translates to profitability.

• Which project should be selected and why? If the projects had the same IRR amounts but different NPV totals, then how would you know which project to select? Explain.

Project 2 should be selected if the projects have the same IRR amounts. Notably, this means that the NPV values will form the basis for differentiating the projects.

• What would happen if both projects had negative NPV totals? Which project would you choose? What do negative NPVs indicate? Explain.

If both projects had negative NPV totals, none of them should be selected. Notably, this is so because negative NPVs indicate a loss venture where a firm would lose money.

• Should we also use the payback method to assist us in project selection? Why or why not? Explain.

The payback method has major disadvantages that discredit it from being used in project selection. Notably, the method fails to account for the time value of money which is crucial. Further, the method usually ignores the cash inflows beyond the payback period, making it unrealistic.

4. The capital structure for Magellan Corporation is shown below. Currently, flotation costs are 13% of market value for a new bond issue and $3 per share for preferred stock. The dividends for common stock were $2.50 last year and have an estimated annual growth rate of 6%. Market prices are $1,020 for bonds, $20 for preferred stock, and $30 for common stock. Assume a 34% tax rate.

Financing Type	% of Future Financing
Bonds (8%, $1k par, 16 year maturity)	36%
Common equity	45%
Preferred stock (5k shares outstanding, $50 par, $1.50 dividend)	19%
Total %	100%

Compute the company’s WACC. Is this WACC considered reasonable given the assumptions and other relevant information? Explain.

WACC = (E/V x Re) + ((D/V x Rd) x (1 – T)) + (Pf/V × Rpf)

Cost of debt (Rd)

80(0.66) + (100-870)16 = 935

60.925/935

= 6.52%

Cost of equity (Re)

Price = D0 × (1+g) / (Re – g)

30 = 2.50 × (1 + 0.06) / (Re – 0.06) (Re – 0.06) = 2.65 / 30

Re = 14.83%

Cost of Preferred stock (Rpf)

Rpf = Preference dividend / (P0 – flotation cost)

Rpf = 1.5 / (20 – 3)

Rpf = 8.82%

WACC total percentage cost of capital= (6.52%×0.36) +(14.83%×0.45) +(8.82%×0.19)

= 2.35 + 6.67 + 1.68

 

= 10.70%

WACC displays the lowest rate at which a business may secure funding. Although Magellan’s WACC is 10.70%, it is composed of bonds, preferred stock with variable interest rates, and common shares.
Since the project evaluation indicates that the investment will generate enough profit to cover the financing risk, this is seen as a reasonable WACC.

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This assignment will allow you to demonstrate the following objectives:

• Compute the net present value, profitability index, and internal rate of return for a given company.
• Predict the best choice for a company based on analysis of financial data.
• Compute a company’s WACC using given percentages.
• Calculate the cost of capital of a stock.
• Computer the after-tax cost of capital for bonds.

Instructions:    Answer the questions directly on this document. When you are finished, select “Save As,” and save the document using this format: Student ID_UnitVIII. Upload this document to BlackBoard as a .doc, docx, or .rtf file. Show all of your work.

1. The Turnip Company plans to issue preferred stock. Currently, the company’s stock sells for $110. Once new stock is issued, the Turnip Company would receive only $90. The dividend rate is 8%, and the par value of the stock is $100. Compute the cost of capital of the stock to your firm. Show all work.
   

   Financial Management Unit VIII Assignment

 

2. The Maximus Corporation is considering a new investment, which would be financed from debt. Maximus could sell new $1,000 par value bonds at a new price of $920. The bonds would mature in 13 years, and the coupon interest rate is 10%. Compute the after-tax cost of capital to Maximus for bonds, assuming a 34% tax rate. Show work.

 

3. Connor Corporation is considering two projects (see below). For your analysis, assume these projects are mutually exclusive with a required rate of return of 10%.

	Project 1	Project 2
Initial investment	$(465,000)	$(700,000)
Cash inflow Year 1	$510,000	$850,000

Compute the following for each project:

• NPV (net present value)
• PI (profitability index)
• IRR (internal rate of return)

Based on your analysis, answer the following questions :

• Which is the best choice? Why?
• Which project should be selected and why? If the projects had the same IRR amounts but different NPV totals, then how would you know which project to select? Explain.
• What would happen if both projects had negative NPV totals? Which project would you choose? What do negative NPVs indicate? Explain.
• Should we also use the payback method to assist us in project selection? Why or why not? Explain.

4. The capital structure for Magellan Corporation is shown below. Currently, flotation costs are 13% of market value for a new bond issue and $3 per share for preferred stock. The dividends for common stock were $2.50 last year and have an estimated annual growth rate of 6%. Market prices are $1,020 for bonds, $20 for preferred stock, and $30 for common stock. Assume a 34% tax rate.

Financing Type	% of Future Financing
Bonds (8%, $1k par, 16 year maturity)	36%
Common equity	45%
Preferred stock (5k shares outstanding, $50 par, $1.50 dividend)	19%
Total %	100%

Compute the company’s WACC. Is this WACC considered reasonable given the assumptions and other relevant information? Explain.