Question

Consider the following information on Huntington Power Co.

Debt: 4,000, 7% semiannual coupon bonds outstanding, $1,000 par value, 18 years to maturity, selling for 102 percent of par; the bonds make semiannual payments. Preferred Stock: 10,000 outstanding with par value of $100 and a market value of 105 and $10 annual dividend. Common Stock: 84,000 shares outstanding, selling for $56 per share, the beta is 2.08

The market risk premium is 5.5%, the risk free rate is 3.5% and Huntington’s tax rate is 32%.

Huntington Power Co. is evaluating two mutually exclusive project that is somewhat riskier than the usual project the firm undertakes; management uses the subjective approach and decided to apply an adjustment factor of +2.1% to the cost of capital for both projects.

Project A is a five-year project that requires an initial fixed asset investment of $2.4 million. The fixed asset falls into the five-year MACRS class. The project is estimated to generate $2,050,000 in annual sales, with costs of $950,000. The project requires an initial investment in net working capital of $285,000 and the fixed asset will have a market value of $225,000 at the end of five years when the project is terminated.

Project B requires an initial fixed asset investment of $1.0 million. The marketing department predicts that sales related to the project will be $920,000 per year for the next five years, after which the market will cease to exist. The machine will be depreciated down to zero over four-year using the straight-line method (depreciable life 4 years while economic life 5 years). Cost of goods sold and operating expenses related to the project are predicted to be 25 percent of sales. The project will also require an addition to net working capital of $150,000 immediately. The asset is expected to have a market value of $120,000 at the end of five years when the project is terminated.

Use the following rates for 5-year MACRS: 20%, 32%, 19.2%, 11.52%, 11.52%, and 5.76%

1) Calculate WACC for the firm.

2) What is the appropriate discount rate for project A and project B (Risk adjusted rate)?

3) Calculate project A’s cash flows for years 0-5

4) Calculate NPV, IRR and PI for project A

5) Calculate project B’s cash flows for year 0-5

6) Calculate NPV, IRR and PI for project B

7) Which project should be accepted if any and why?

8) What is the exact NPV profile’s crossover rate (incremental IRR)?

Answer 1

Question 1.

WACC = ( Weight of debt * Cost of debt ) + ( Weight of preferred stock * Cost of preferred stock ) + ( Weight of common stock * Cost of common stock )

Cost of debt = [Coupon interest * ( Current price - Par value ) ] / ( Current price + Par value ) * ( 1 / 2 )

=[ ($1000 * 7%) * ( $1020 - $1000 ) ] / ( $1020 + $1000 ) * ( 1 / 2 )

= $90 / $1010

= 8.91%

After tax cost of debt = 8.91% * ( 1 - 0.32 )

= 6.06%

Cost of preferred stock =  Preferred dividend / Market price of preferred stock

= $10 / $105

= 9.52%

Cost of common stock = Risk free rate + Beat ( Market risk premium )

= 3.5% + 2.08 ( 5.5% )

= 14.94%

In the calculation of weight of securities market value is taken for share.

Securities	Share	Working	Weight
Debt	$4,080,000	( 4000 * $1020 )	0.415
Preferred stock	$1,050,000	( 10000 * $105 )	0.107
Common stock	$4,704,000	( 84000 * $56 )	0.478
Total	$9,834,000		1

WACC = ( 0.415 * 6.06% ) + ( 0.107 * 9.52% ) + ( 0.478 * 14.94% )

= 10.67%

Companies WACC is 10.67%