Universal Foods has a debt-to-value ratio of 40%, its debt is currently selling on a yield of 6%, and its cost of equity is 12%. The corporate tax rate is 40%. The company is now evaluating a new venture into home computer systems. The internal rate of return on this venture is estimated at 13.4%. WACCs of firms in the personal computer industry tend to average around 14%
What is Universal's WACC?
b. Will Universal make the correct decision if it discounts cash flows on the proposed venture at the firm's WACC?
c. Should the new project be pursued
Answer:
A.) 8.64%
B.) No
C.) No
Step-by-step explanation:
Given the following :
DEBT-TO-VALUE ratio (D/V) = 40% = 0.4
Debt rate (rD) = 6% = 0.06
Corporate tax( tC) = 40% = 0.4
Cost of Equity (rEquity) = 12% = 0.12
EQUITY-TO-VALUE ratio (E/V) = (1 - 0.4) =0.6
rEquity = (D / V) × (1 - Tc)rDebt + (E / V) × rEquity
= 0.40 × (1 - 0.4)(0.06) + (0.6) × 0.12
= 0.0144 + 0.072
= 0.0864
= 8.64%
B) No, The IRR is above the company WACC
C.) No, NPV will be negative as IRR is less than 14%
a. Universal Foods' Weighted Average Cost of Capital (WACC) = 8.16% (7.2% + 0.96%)
b. Universal Foods will make the correct decision by discounting the cash flows on this venture at the firm's WACC because it is always lower than the estimated internal rate of return (IRR).
c. Universal Foods should pursue the project since the internal rate of return is estimated at 13.4%, and Universal Foods' WACC is lower than the industry average.
Data and Calculations:
Debt-to-value ratio = 40%
Debt's yield rate = 6%
Corporate tax rate = 40%
Weighted cost of debt = 0.96% (6% x (1 -60%) x 40%)
Cost of equity = 12%
Weighted cost of equity = 7.2% (12% x (1 -40%)
Industry Average WACC = 14%
Internal rate of return = 13.4%
Question Completion:
a. What is Universal's WACC?
b. Will Universal make the correct decision if it discounts cash flows on the proposed venture at the firm's WACC?
c. Should the new project be pursued?
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