Based in Winnipeg, Manitoba, Clearview Security Technologies Inc. (Clearview) was founded to provide security systems, facilities controls, and related services. Clearview established a solid reputation for quality and the business grew, thanks to strong relationships with large long-term customers in Canada and the United States. Clearview has experienced little competitive pressure in its core market and the company’s offerings are standardized, enabled by significant technological and financial barriers to entry. The Research and Innovation Group (RIG) is the development side of the company. Where Clearview’s primary lines are standardized, the RIG is all over the map. Clearview uses this smaller division to provide contract software and consulting to a wide range of business types. The RIG is considering a new contract that will strain resources for not only the RIG but the entire company. The project involves new technology, a new customer, and a new geographic area. The director of operations has warned you that it will be substantially riskier than anything Clearview does in its core business. 

With an upfront cost of C$8.5 million, managers want to develop an understanding of expected financing costs. The director of finance explained that understanding the cost of capital will be a key part of maintaining and improving Clearview’s competitive edge. RIG managers have noticed competing bids for the contract and it is expected that margins will be pushed down. You have been asked to calculate the company’s weighted average cost of capital (WACC), based on the following information. Over the past five years, the firm’s stock price and earnings have both grown at approximately 5 percent a year. Clearview recently paid a dividend of $1.25 a share on earnings per share of $2.50 and the common shares trade at $45 per share with 250,000 shares outstanding. There are no preferred shares. You check the Bank of Canada’s web page and the current 91-day T-bill yield is 1.25 percent and the long Canada bond yield is 2.5 percent. On your desk is a series of reports by major investment banks that indicate a long-run return on the Canadian equity market of 8 percent to 9 percent a year, and a note that Clearview’s stock beta has been about 0.90. Clearview also has 25-year bonds outstanding with a $1,000 face value, 6.5 percent semiannual coupon, and 20 years to maturity. The bonds currently trade at 115. The initial bond offering raised $15,500,000 and sold at par. The firm’s marginal tax rate is 30 percent. 

1. The cost of equity and debt a. Calculate Clearview’s cost of equity using the constant growth model approach and the CAPM approach. Take the arithmetic average of the two results. b. Determine Clearview’s after-tax cost of debt. Solving the cost of debt is best done with a financial calculator, although trial and error will also yield the correct result. The bond valuation formula is required in this approach, substituting values for kb until the bond value is determined. A third method for determining the cost of debt is an approximation formula: kb approx. = ((annual coupon + (face − price))/years remaining)/((face + price)/2). The trial and error approach can be completed much faster if the approximation method is used first, to narrow the trial and error range. 

2. The weight of equity and debt 

a. Calculate the weights of equity and debt in Clearview’s capital structure. 

b. Determine Clearview’s WACC. 

3. The company will use its current capital structure to set target weights for debt and equity, with flotation costs of 2 percent for long-term debt and 7.5 percent for equity. 

• How much capital must Clearview raise in order to cover the project cost and all flotation charges? 4. Determining the NPV The RIG project is expected to generate revenues of $1,400,000 per year before tax, in each of the next 10 years. The PV (CCA tax shield) method for depreciation is appropriate using the half-year rule. The applicable CCA rate is 30%, salvage value will be zero, and net working capital considerations are minimal. Determine the NPV of the project using the WACC calculated earlier as the discount rate. Rework the analysis in part using a discount rate of 10%. What is the revised NPV of the project? 

5. The RIG Project Decision The director of finance asked you to discount the expected future cash flows for the RIG project using Clearview’s WACC and to determine the NPV of the project. The director remains confident that using Clearview’s WACC is appropriate because the WACC considers many key aspects of the business’s finances. 

a. How should you respond? 

b. What would be the justification for using a higher discount rate, as introduced in question 4 b? 

c. Describe a situation where using a lower discount rate than a firm’s current WACC might be appropriate. 

d. In considering the project’s value, should the CCA tax shields be valued using the same discount rate as the firm’s after-tax net revenues?

Answer rating: 100% (QA)

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