Problem 1
Given that a companys risk-free rate is 1%, the S&P 500 average return is 6%, and a firm has a beta of 0.8, compute the Weighted Average Cost of Capital for the firm given that the firm can borrow from the bank at (on average) an interest rate of 4%. The balance sheet shows that there is $300 million of shareholder equity, and $100 million of long-term debt.
Problem 2
The same company as the firm in Problem 1 (i.e. assume the WACC that you have computed above) is now contemplating the following project that will generate the following cash flows:
Year 1 2 3 4 5
Cash flow 12 12 4 4 7
The initial investment is 33 (all number are $ millions).
Should the firm proceed with the investment?
Does it make a difference if there is uncertainty regarding the cash flows: there is only an 85% chance that the cash will be realized. Assume that the cash flows are reduced by 15% accordingly.