Must Be New And Original Work Not Given To Other Stud 751772
Must Be New And Original Work Not Given To Other Studentsassignment S
Scenario: You work for an investment banking firm and have been asked by management of Vestor Corporation (not real), a software development company, to calculate its weighted average cost of capital, to use in evaluating a new company investment. The firm is considering a new investment in a warehousing facility, which it believes will generate an internal rate of return of 11.5%. The market value of Vestor's capital structure is as follows: Bonds $10,000,000, Preferred Stock $2,000,000, Common Stock $8,000,000. To finance the investment, Vestor has issued 20-year bonds with a $1,000 par value, 6% coupon rate, and at a market price of $950. Preferred stock paying a $2.50 annual dividend was sold for $25 per share. Common stock of Vestor is currently selling for $50 per share and has a Beta of 1.2. The firm's tax rate is 34%. The expected market return of the S&P 500 is 13%, and the 10-Year Treasury note is currently yielding 3.5%.
Determine the appropriate discount rate (WACC) Vestor should use to evaluate the warehousing project, and assess whether Vestor should proceed with the investment. Prepare your analysis in a minimum of 250 words in Microsoft Word, including all calculations and analysis, presented in tables if needed.
Paper For Above instruction
Introduction
The evaluation of capital projects requires an accurate estimation of the firm’s cost of capital, which serves as the discount rate for assessing the viability of new investments. The weighted average cost of capital (WACC) incorporates the costs of equity, debt, and preferred stock, weighted by their proportions in the firm's capital structure. For Vestor Corporation, calculating the WACC involves analyzing market data, bond and stock specifics, and prevailing economic conditions to ensure an accurate reflection of the firm's cost of capital. This analysis focuses on determining the appropriate WACC for evaluating a new warehousing facility expected to yield an internal rate of return (IRR) of 11.5%.
Calculating the Cost of Debt (Kd)
The debt consists of 20-year bonds with a par value of $1,000, a coupon rate of 6%, and a current market price of $950. The cost of debt (before tax) can be approximated using the yield to maturity (YTM) formula, which considers the current price, face value, coupon payments, and time to maturity.
Using a financial calculator or Excel's RATE function:
- Coupon Payment = 6% of $1,000 = $60
- Number of periods = 20
- Present value = -950 (negative as cash outflow)
- Future value = 1,000
Excel formula: =RATE(20,60,-950,1000) ≈ 6.41%
Since interest expense is tax-deductible, the after-tax cost of debt (Kd) is:
Kd = 6.41% × (1 - 0.34) ≈ 4.24%
Calculating the Cost of Preferred Stock (Kp)
Preferred stock pays an annual dividend of $2.50 and was sold at $25 per share:
Kp = Dividend / Price = $2.50 / $25 = 10%
Calculating the Cost of Equity (Ke)
The Capital Asset Pricing Model (CAPM) is used:
Ke = Risk-Free Rate + Beta × (Market Return - Risk-Free Rate)
Using the given data:
- Risk-Free Rate = 3.5% (10-Year Treasury yield)
- Beta = 1.2
- Market Return = 13%
Ke = 3.5% + 1.2 × (13% - 3.5%) = 3.5% + 1.2 × 9.5% = 3.5% + 11.4% = 14.9%
Calculating the Capital Structure Weights
The market values of each component are given:
| Source of Capital | Market Value | Weight in Capital Structure |
|---|---|---|
| Bonds | $10,000,000 | 10,000,000 / 20,000,000 = 0.50 |
| Preferred Stock | $2,000,000 | 2,000,000 / 20,000,000 = 0.10 |
| Common Stock | $8,000,000 | 8,000,000 / 20,000,000 = 0.40 |
Calculating WACC
Applying the weights and costs:
WACC = (Wd × Kd) + (Wp × Kp) + (We × Ke)
WACC = (0.50 × 4.24%) + (0.10 × 10%) + (0.40 × 14.9%)
WACC = 2.12% + 1% + 5.96% = 9.08%
Analysis and Investment Decision
The calculated WACC of approximately 9.08% serves as the minimum required rate of return to justify the warehousing project. Given that Vestor expects an IRR of 11.5%, which exceeds the WACC, the project appears financially promising. The IRR greater than the WACC indicates the project can generate sufficient returns above the cost of capital, adding value to the firm.
Furthermore, considering the economic environment characterized by a relatively low risk-free rate and a moderate market risk premium, Vestor’s decision to proceed based on IRR surpassing WACC aligns with prudent investment strategy. Vestor should, therefore, proceed with the warehousing investment, as it is expected to contribute positively to the company's value.
In conclusion, the WACC calculation confirms that Vestor’s hurdle rate for investment evaluation is approximately 9.08%. Since the expected IRR of the project exceeds this rate, the investment is financially justified and should be considered by management.
References
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- Ross, S. A., Westerfield, R. W., & Jordan, B. D. (2022). Fundamentals of Corporate Finance (12th ed.). McGraw-Hill Education.
- Brigham, E. F., & Ehrhardt, M. C. (2019). Financial Management: Theory & Practice (16th ed.). Cengage Learning.
- Investopedia. (2023). Cost of Debt - YTM Formula & How to Calculate. https://www.investopedia.com/terms/c/costofdebt.asp
- U.S. Department of the Treasury. (2023). Treasury Yield Curve Rates. https://home.treasury.gov/policy-issues/financing-government/debt-management/interest-rates
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