Reference no: EM132996281
Question - Riffa Shoes Co. is considering two alternative investment proposals.
- The first proposal calls for investment in plant and equipment to produce a new line of footwear.
- The second proposal calls for investment in plant and equipment to expand a current and successful line of footwear.
The company will choose one project or the other this year, but it will not invest in both.
|
Year
|
New Line
|
Expand Line
|
|
0
|
($18,000,000)
|
($10,000,000)
|
|
1
|
$5,500,000
|
$5,500,000
|
|
2
|
$5,500,000
|
$5,500,000
|
|
3
|
$5,500,000
|
$4,000,000
|
|
4
|
$5,500,000
|
$0
|
|
5
|
$5,500,000
|
$0
|
Use the information provided below to calculate Riffa Shoes' weighted average cost of capital (WACC) to evaluate these two proposals. The following questions are asked to provide a guide for your analysis.
The WACC can be estimated based on Riffa Shoes' long-term (capital) financing sources, including the use of retained earnings, and the use of proceeds from new issues of corporate bonds, preferred stock, and common stock. Issuance costs (flotation costs) for new issues are 2% for new issues of corporate bonds, 4% for new issues of preferred stock, and 20% for new issue of common stock.
Riffa Shoes' target capital structure is 25% debt, 15% preferred stock, and 60% equity.
Riffa Shoes' marginal tax rate is 28%. Perry Shoes has $12,600,000 million in retained earnings.
Corporate Bonds
Riffa Shoes can sell 9.5 % coupon, 30- year bonds (coupons are paid semi-annually) for $934.84. Riffa Shoes can issue an unlimited amount of new bonds at the same rate. The risk premium for Riffa Shoes' common stock is estimated to be 4% above its bond yield and is based on other companies in Riffa Shoes' risk category.
Preferred Stock
Riffa Shoes' preferred stock sells for $30.50 per share, the dividend rate is 7%, and the par value of this preferred stock is $50.
Common Stock
Riffa Shoes' common stock sells for $22.43 per share, the growth rate is 6%, and Riffa Shoes just paid a dividend for last year in the amount of $1.56 (D0 = $1.56).
Answer the following questions:
a. What is Riffa Shoes' cost of a new issue of preferred stock?
b. What is Riffa Shoes' cost of common stock [using the Dividend Discount Model]
c. Given the cost of debt (Rd) of 7.5%, what is Riffa Shoes' cost of capital (WACC)?
d. Calculate the net present value (NPV) of each project and based on this criteria for which project would you recommend acceptance (use WACC in question [c] as the discount rate)? Explain your decision.