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1. Bob’s Country Bunker (BCB), a chain of economically priced motels in the Midwestern United States has reviewed its current target structure of 40% debt and 60% equity. It can issue debt at a rate of 9%. The last dividend paid on its stock was $1.25. The company is doing very well and expects to maintain its current growth rate of 5%. The firm’s tax rate is 35%, and the common stock currently sells at $29. The company is considering two projects: Project A which has an expected rate of return of 14%, and Project B which has an expected rate of return of 10%. Both projects are equally risky and the firm can accept both.
a. What is the cost of common equity?
b. What is the WACC?
c. Which projects should BCB accept?
2. Your firm is considering two projects: Project A and Project B with the following cash flows:
A YEAR B YEAR
-$75 0 -$60 0
$15 1 $20 1
$33 2 $13 2
$44 3 $15 3
$55 4 $18 4
a. Calculate the NPVs based on WACCs of 5% and 7%
b. What are the IRRs based on the WACCs?
c. Calculate the payback period and discounted payback period
d. Which projects should the firm accept if they are independent, based on the NPV, IRR, payback period, and discounted payback period methods? Assume your firm requires projects to break even in three years
To answer your questions step-by-step:
1. Cost of Common Equity:
To calculate the cost of common equity, we can use the dividend growth model (also known as the Gordon Growth Model). The formula is as follows:
Cost of Common Equity = (Dividend / Stock Price) + Growth Rate
Dividend = $1.25
Stock Price = $29
Growth Rate = 5%
Cost of Common Equity = (1.25 / 29) + 0.05
2. Calculate the result for the above equation to find the cost of common equity.
2. WACC:
The Weighted Average Cost of Capital (WACC) is the average rate of return a company must earn on its existing assets to keep its stock value unchanged. It is calculated by weighting the cost of debt and the cost of equity by their respective percentages in the company's capital structure.
WACC = (Equity Weight × Cost of Equity) + (Debt Weight × Cost of Debt)
Given:
Debt Weight = 40%
Cost of Debt = 9%
Equity Weight = 60%
Cost of Equity (calculated in step 1) = ...
Plug in the values into the equation and calculate the WACC.
3. Project Acceptance:
To determine which projects BCB should accept, we need to compare the expected rate of return of each project (Project A and Project B) with the WACC.
a. Compare the expected rate of return of Project A with the WACC and determine if it is higher or lower.
b. Compare the expected rate of return of Project B with the WACC and determine if it is higher or lower.
c. If the expected rate of return of a project is higher than the WACC, then BCB should accept that project. If the expected rate of return is lower, then it may not be financially advisable to accept the project.
For the second part of your question:
1. Calculate NPVs:
To calculate the Net Present Value (NPV), we need to discount the cash flows from each year using the appropriate discount rate (WACC).
a. Plug in the cash flows for each year (A and B) and discount rate (5%) into the NPV formula:
NPV = (Cash Flow / (1 + Discount Rate)^Years) - Initial Investment
b. Repeat the process for a discount rate of 7%.
2. Calculate IRRs:
The Internal Rate of Return (IRR) is the discount rate that makes the NPV of a project equal to zero. We can calculate the IRR using trial and error or by using spreadsheet software.
a. Repeat the process from step 1 but set the NPV equal to zero and solve for the discount rate. This will give you the IRR.
3. Calculate Payback Period:
The Payback Period is the time it takes for the initial investment to be recovered.
a. Add up the cash flows until the cumulative cash flow is positive.
b. The payback period is the number of years it takes to reach a positive cumulative cash flow.
4. Calculate Discounted Payback Period:
The Discounted Payback Period is similar to the payback period, but the cash flows are discounted using the appropriate discount rate.
a. Repeat the process from step 3 but use the discounted cash flows (using the WACC) instead of the actual cash flows.
5. Project Acceptance:
To determine which projects the firm should accept, compare the NPV, IRR, payback period, and discounted payback period for each project.
a. If the NPV is positive, the IRR is greater than the discount rate (WACC), and the payback period and discounted payback period are less than the required time (3 years), then the project should be accepted.
Repeat the process for both Project A and Project B and evaluate the results to determine which projects the firm should accept.
I hope this helps! Let me know if you have any further questions.
To answer the questions for the two problems, we need to use various financial calculations such as cost of common equity, weighted average cost of capital (WACC), net present value (NPV), internal rate of return (IRR), payback period, and discounted payback period.
Let's break down each question and explain how to solve them:
Problem 1:
a. To calculate the cost of common equity, we can use the dividend growth model (also known as the Gordon growth model):
Cost of Common Equity = Dividend / Current Stock Price + Growth Rate
In this case, the dividend is $1.25, the current stock price is $29, and the growth rate is 5%. Plugging these values into the formula, we have:
Cost of Common Equity = $1.25 / $29 + 5% = 9.31%
b. To calculate the WACC, we need to consider the weights and costs of each component of the capital structure. In this case, the debt component has a weight of 40% and a cost of 9%, while the equity component has a weight of 60% and a cost of 9.31% (calculated in part a).
WACC = (Weight of Debt * Cost of Debt) + (Weight of Equity * Cost of Equity)
WACC = (0.4 * 9%) + (0.6 * 9.31%) = 5.62%
c. To determine which projects BCB should accept, we can compare the expected rate of return of each project with the WACC. Both Project A and Project B have expected rates of return higher than the WACC, which means they are expected to generate returns higher than the cost of capital. Therefore, BCB should accept both projects.
Problem 2:
a. To calculate the NPV based on different WACCs (5% and 7%), we need to discount the cash flows of each project to their present value and subtract the initial investment:
NPV = CF0 / (1 + WACC)^0 + CF1 / (1 + WACC)^1 + CF2 / (1 + WACC)^2 + CF3 / (1 + WACC)^3 + CF4 / (1 + WACC)^4 - Initial Investment
Substitute the cash flow values for each year and the respective WACC in the formula to calculate the NPVs.
b. To calculate the IRRs based on the WACCs, we need to find the discount rate that makes the NPV equal to zero. This can be done either through trial and error or using specialized software or financial calculators.
c. To calculate the payback period, we need to determine the number of years it takes for the cumulative cash flows to equal or exceed the initial investment. The discounted payback period is calculated in a similar manner, but using the discounted cash flows.
d. To determine which projects the firm should accept based on various methods, we can compare the calculated values. If a project has a positive NPV, an IRR higher than the required rate of return, a payback period less than the firm's requirement, and a discounted payback period less than the firm's requirement, then the project should be accepted. Compare the results for each project and make the decision accordingly.
It's important to note that the exact calculations and results may vary depending on the specific values provided in the problem statement. Make sure to use the given values and formulas correctly to derive the correct answers.