1 views You have the following initial information on CMR Co. on which to base your calculations and discussion for questions 1) and 2): • Current long-term and target debt-equity ratio = 1:4 • Corporate tax rate = 30% • Expected Inflation = 1.75% • Equity beta = 1.6385 • Debt beta = 0.2055 • Expected market premium (rM – rF) = 6.00% • Risk-free rate (rF) = 2.15% 1) The CEO of CMR Co., for which you are CFO, has requested that you evaluate a potential investment in a new project. The proposed project requires an initial outlay of $7.15 billion. Once completed (1 year from initial outlay) it will provide a real net cash flow of $575 million in perpetuity following its completion. It has the same business risk as CMR Co.’s existing activities and will be funded using the firm’s current target D:E ratio. a) What is the nominal weighted-average cost of capital (WACC) for this project? b) As CFO, do you recommend investment in this project? Justify your answer (numerically).
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
You have the following initial information on CMR Co. on which to base your calculations and discussion for questions 1) and 2):
• Current long-term and target debt-equity ratio = 1:4
• Corporate tax rate = 30%
• Expected Inflation = 1.75%
• Equity beta = 1.6385
• Debt beta = 0.2055
• Expected market premium (rM – rF) = 6.00%
• Risk-free rate (rF) = 2.15%
1) The CEO of CMR Co., for which you are CFO, has requested that you evaluate a potential investment in a new project. The proposed project requires an initial outlay of $7.15 billion. Once completed (1 year from initial outlay) it will provide a real net cash flow of $575 million in perpetuity following its completion. It has the same business risk as CMR Co.’s existing activities and will be funded using the firm’s current target D:E ratio.
a) What is the nominal weighted-average cost of capital (WACC) for this project?
b) As CFO, do you recommend investment in this project? Justify your answer (numerically).
2) Assume now a firm that is an existing customer of CMR Co. is considering a buyout of CMR Co. to allow them to integrate production activities. The potential acquiring firm’s management has approached an investment bank for advice. The bank believes that the firm can gear CMR Co. to a higher level, given that its existing management has been highly conservative in its use of debt. It also notes that the customer’s firm has the same cost of debt as that of CMR Co. Thus, it has suggested use of a target debt-equity ratio of 2:6 when undertaking valuation calculations.
a) What would the required
b) Would the above project described in 1) be viable for the new owner of BFS Co.? Justify your answer (numerically).
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