Question 3 (20 marks)

ABC Ltd has decided to use the weighted average cost of capital (WACC) to discount the after-tax cash flows associated with project evaluation. You have been given the task of determining the after-tax WACC of the firm. You are informed that ABC Ltd uses the following securities to fund its operation:

• 40,000 individual bonds with 6%, 10-year $1,000 face value that were issued 5 years ago have 5 years remaining and offer a coupon that is paid half-yearly. The current market interest rate for these bonds is 7% per annum.
• 2,500,000 ordinary shares, which recently paid a dividend of 60 cents. Dividends are expected to grow at 5% per annum perpetually. The current share price is $30.
• Using the historical data, the covariance between the returns of ABC Ltd and the returns of S&P/ASX200 is found to be 0.0015 and the standard deviation of S&P/ASX 200 returns is 0.04. The risk-free rate is currently 3% per annum, and the market risk premium is 6% per annum.
• For the cost of equity calculation, ABC Ltd has decided to use the average of two values obtained from the constant growth model and the CAPM.
• 1,000,000 preference shares, which pay an annual dividend of 50 cents. Each preference share trades at a market price of $10.
• The company tax rate is 30%.

Required:

a) Compute the WACC. (15 marks)

b) Your company is considering an acquisition of Sun Ltd whose WACC is 10%. Your companys purchase of Sun Ltd will cost 50 million, and will generate cash flows that start at $10 million per year for the next 10 years and the cost of environmental clean-up is expected to be $500,000 per year starting from Year 1 in perpetuity. What is the NPV of the acquisition? Should your company go ahead with the acquisition and why? (5 marks)