required as given above

Question 1

Rollins Corporation is estimating its WACC. Its target capital structure is 40% debt and 60% common equity. Its bonds have par value of $1,000, a 8% coupon, paid semi-annually, a current maturity of 7 years, and sell for $901.04. Rollins' beta is 1.5, the risk-free rate is 9%, and the market risk premium is 6%. Rollin is currently selling for $25 a share. The firm's marginal tax rate is 40%.

Required:

a. What is Rollins' WACC?

b. Discuss the problems of estimating the cost of capital for privately owned firms.

Question 2

Jack's Construction Co. has 80,000 bonds outstanding that are selling at par value ($1,000). Bonds with similar characteristics are yielding 8.5%. The company also has 4 million shares of common stock outstanding. The stock has a beta of 1.1 and sells for $40 a share. The U.S. Treasury bill is yielding 4% and the market risk premium is 8%. Jack's tax rate is 35%. What is Jack's cost of equity and its weighted average cost of capital?

Question 3

Och, Inc., is considering a new project that will result in initial after-tax cash savings of $3.5 million at the end of the first year, and these savings will grow at a rate of 4 percent per year indefinitely. The firm has a target debt-to-equity ratio of 0.55, a cost of equity of 13 percent,, and an after-tax cost of debt of 5.5 percent. The cost-saving proposal is somewhat riskier than the usual projects the firm undertakes and management applies an adjustment factor of +2 percent to the cost of capital for such risky projects. Under what circumstance should Och take on the project?

Question 1:

a. WACC = 12.43%

B. The problems involved in estimating the cost of capital include the weights to be assigned to the sources of capital and the costs to be used in measuring the sources of capital. There are views stating that the book value of the sources must be used in measuring capital, as well as in determining the weights of such sources. However, there are also sources stating that the market value must be used in assigning costs and in determining weights. 

Question 2:

Cost of Equity = 12.8%

WACC = 10.38%

Question 3:

The Net Present Value of the project is $ 41,966,426.86. If the NPV is positive, the project should be accepted. However, other bases of evaluation should also be taken into account such as internal rate of return, payback method and etc. 

Step-by-step explanation

Question 1:

1. WACC = (After-tax cost of debt * Debt Ratio) + (Cost of Common Equity * Equity Ratio)

CAPM Model:

Cost of Equity = Risk-free Rate + (Beta * Market Risk Premium) 
Cost of Equity = 9% + (1.5 * 6%)
Cost of Equity = 18 %

Cost of Debt: Since the Fair Value differs from the Par Value, we may assume that the stated rate of 7% is not the effective rate. Hence, we should use the formula below to compute for the effective rate.

Cost of Debt =  [ Interest + ((Fair Value - Proceeds) / term in years] / [ (FV + Proceeds) / 2]

Cost of Debt, semi-annual = [ (1,000 * 8% / 2) + ((901.04 - 1,000) / (7 * 2 years))] / [( 901.04 + 1,000) /2] 

Cost of Debt, semi-annual = 3.4 % 
Cost of Debt, annual = 3.4% * 2 = 6.8%

After-tax Cost of Debt = cost of debt * (100% - tax rate) 
After-tax Cost of Debt = 6.8% * (100% - 40%)
After-tax Cost of Debt = 4.08%

WACC = (After-tax cost of debt * Debt Ratio) + (Cost of Common Equity * Equity Ratio)

WACC = (4.08% * 40%) + (18% * 60%)
WACC = 12.43%

Question 2:

Cost of Equity = Risk-free Rate + (Beta * Market Risk Premium)

Cost of Equity = 4% + (1.1 * 8%)
Cost of Equity = 12.8%

After-tax Cost of Debt = cost of debt * (100% - tax rate)
After-tax Cost of Debt = 8.5% * (100% - 35%)
After-tax Cost of Debt = 5.53%

Computation Weights:

For debt: 80,000 bonds * 1,000 = 80,000,000
For equity: 4, 000,000 shares * 40 = 160,000,000
TOTAL : 240,000,000

For Debt: 80,000,000/ 240,000,000 = 1/3
For Equity: 160,000,000/ 240,000,000 = 2/3

WACC = (After-tax cost of debt * Debt Ratio) + (Cost of Common Equity * Equity Ratio)

WACC = ( 5.53% * 1/3) + ( 12.8% * 2/3)
WACC = 10.38%

Question 3:

Net Present Value of Project with Perpetual Cash Flows = Periodic net inflows / (Adjusted WACC - Growth Rate)

Periodic net inflows = 3.5 million

Weights for WACC Computation

Debt/ Equity = 0.55

Hence, there is $0.55 debt per $1 equity. Thus the weights would be;

Debt: 0.55 / 1.55
Equity: 1/ 1.55

WACC = [5.5 % * (0.55/1.55)] + [13% * (1/1.55])
WACC = 10.34%

Adjusted WACC = 10.34% + 2% Adjustment factor 
Adjusted WACC = 12.34%

Growth Rate = 4%

Thus:

NPV = 3, 500,000 / (12.34% - 4%)
NPV = 41,966,426.86