Mba611: Cost of Capital

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- Is the project a good one?

Solution:

Calculate NPV of

-100

50

30

20

10

10

10

10

10

10

10

Yes, since NPV is $21.85.

- What percent of the project cost could be funded from the bond issue?

Solution:

Use the cash flows that could be used for bond issuance

45

24

14

6

5

5

5

5

5

5

–find PV, which is $90.23.

Hence, 90.23% of the project could be funded by the bond issuance.

- Bond holders do not like unequal payments – they like the same coupon payments every year. Assume that since the discount rate is 10%, the issued bond coupon is 10% as well. What would be the structure of the bond?

Suggested solution – it should vary for each student – depending upon students’ assumptions.

My solution: Since part 2 of the problem says that I can get $90.23 from the toll collections that could be used for paying off my debt, I could possibly get $90.23 of funding. Hence, by issuing a bond today of the same $, I can fund 90.23% of the project.

I would sell a bond of $90.23 for 5 years (you can select any amount for any maturity – as long as it can be supported from the projected profits/any other suggestions you may have).

Therefore, Bond cash flows are

9.023

9.023

9.023

9.023

99.253 (9.023+90.23)

PV of the bond is $90.23.

Hint: You could make the duration of the bond shorter or longer.

– but the longer you make, higher the coupon rate will be . Why?

– shorter you make, more difficult it will be to get funded ---- since your first cash flow comes after one year, which is $45 after expenses (see part 2 of the problem), you cannot possibly get a funding of $90.23 if the duration of the bond is one-year.

- After accounting for the bond issuance, how much the community must spend on the project today?

Solution:

The community must spend $100-90.23 = $ 9.77.