question archive Valley Flights, Inc
Valley Flights, Inc
Subject:StatisticsPrice:3.87 Bought7
Valley Flights, Inc. has a capital structure made up of 40% debt and 60% equity and a tax rate of 30%. A new issue of $1,000 par bonds maturing in 20 years can be issued with a coupon of 9% at a price of $1,098.18 with no flotation costs. The firm has no internal equity available for investment at this time, but can issue new common stock at a price of $45. The next expected dividend on the stock is $2.70. The dividend for the firm is expected to grow at constant annual rate of 5% per year indefinitely. Flotation costs on new equity will be $7.00 per share. The company has the following independent investment projects available:
Project Initial Outlay IRR
1 $100,000 10%
2 $10,000 8.5%
3 $50,000 12.5%
Which of the above projects should the company take on?
A. Project 3 only
B. Projects 1, 2 and 3
C. Projects 1 and 3
D. Projects 1 and 2
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Answer:
Cost of equity
P=45
D1 = 2.70
G= 5%
F = 7
Cost of equity Ke = D1/ (P-F) +g
=2.70/(45-7) + 0.05
= 12.11%
WACC = Ke xWe + Kd x Wd
= 12.11% x 0.60 +5.60% x0.40
=9.51%
If IRR is greater than WACC, then only we can choose that project.
We have projects 1 and 3 with IRR greater than 9.51%, so they should be selected. Hence option C is correct.
PFA
