Reference no: EM132746393

Problem - Kelly Wine is considering a new project for its expansion and the CFO has asked you to work out an appropriate discount rate to use when evaluating this project.

Kelly Wine's current capital structure is as follows:

Source of capital	Book value	Market value
Debts	$1,500,000	$1,650,000
Ordinary share capital	$2,000,000	$2,650,000
Total	$3,500,000	$4,300,000

To finance the purchase, Kelly Wine can sell 10-year bonds paying annual coupon interest at a rate of 8% with the face value of $1,000. The bond is expected to be sold at $980.

Ordinary shares are currently traded at $32.5. The company recently paid a dividend of $2.5 this year and dividends are expected to grow by an average of 4% per year for the indefinite future.

The current company's tax rate is 30%.

Required -

A - Calculate the after-tax cost for each source of capital (debts and ordinary shares).

B - Assuming that the appropriate discount rate for the project is the firm's cost of capital. Determine the discount rate to be used for evaluating the project.

C - Instead of using the dividend cash flow approach used to answer question (a), your manager asks you to use the Capital Asset Pricing Model approach to value the cost of ordinary shares. What is the firm's cost of capital for the company under this method? Assuming that Treasury bond yield is 3.5%, the average market return is 13.5% and Kelly Wine's ordinary share has a beta of 1.05.

D - Consider your answer in question (b) and (c), if Kelly Wine has other 8 vineyards across Australia, which discount rate do you think the management should use for evaluating this new project? Justify your answer.