Question 2

Based in Halifax, Nova Scotia, Clear Technology (Clear) was founded to provide security systems, facilities controls, and related services. Clear 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. Clear 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 Group (RG) is the development side of the company. Where Clear's primary lines are standardized, the RG is all over the map. Clear uses this smaller division to provide contract software and consulting to a wide range of business types.

The RG is considering a new contract that will strain resources for not only the RG, 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 more risky than anything Clear does in its core business. With an upfront cost of C$7.5 million, managers want to develop an understanding of expected financing costs. The director of finance explained that understanding cost of capital will be a key part of maintaining and improving Clearview's competitive edge. RG 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. Clear recently paid a dividend of $1.5 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 3 percent and the long Canada bond yield is 3.5 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 9 percent to 10 percent a year, and a note that Clear's stock beta has been about 1.1. Clear also has 25-year bonds outstanding with a $1,000 face value, 6.5 percent semi-annual coupon, and 20 years to maturity. The bonds currently trade at 113. 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

1. Calculate Clear's cost of equity using the constant growth model approach and the CAPM approach. Take the arithmetic average of the two results. 2. Determine Clear's after-tax cost of debt. 2. The weight of equity and debt 1. Calculate the weights of equity and debt in Clear's capital structure. 2. Determine Clear'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 Clear raise in order to cover the project cost and all flotation charges? 4. Determining the NPV The RG 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. (NOTE: PV of the tax shield is $ 1,831,056. No need to calculate it)