The capital structure of a firm consists of debt and equity. The firm has 100,000 bonds outstanding that are selling at par value. The par value of the bonds is $1,000. Bonds with similar characteristics are yielding a before-tax return of 8%. The company also has 5,000,000 shares of common stock outstanding. The stock has a beta of 1.60 and sells for $60 a share. The annual rate of return on U.S. Treasury bills is 5% and the annual market rate of return is 11 percent. The firms tax rate is 25 percent.
a) Find the companys weighted average cost of capital (WACC or RWACC).
b) The firm is considering a new project that is expected to generate annual operating cash flow (OCF) of $2,000,000 for five years. The project requires an initial investment (or initial cost) of $5,000,000. The assets used in the project will have a before-tax market value (salvage value) of $1,000,000 at the end of the project in year 5. Assume that the assets are fully depreciated over five-year life of the project and the book value at the end of year 5 is zero. The project also requires an initial investment in net working capital of $400,000, which is fully recoverable at the end of the project (i.e., year 5). The project has the same risk as the overall firm. Find the net present value (NPV) of the project.