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 NPV, IRR and PI for project B

Answer 1

CALCULATION OF DISCOUNT RATE AND WACC
		AFTER TAX COSTS:
		Debt
		Face value of each Bond	$1,000
		Coupon Rate	7.00%
	Pmt	Semi annual Coupon Payment=1000*7%*(1/2)	$35.00
	Nper	Number of payments	36	(18*2)
	Pv	Current marke Value of each Bond	$1,020.00
	Fv	Amount to paid at maturity	$1,000
	RATE	Semi annual Yield To Maturity(Using RATE function of excel with Nper=36,Pmt=35,Pv=-1020,Fv=1000)(Excel command: RATE(36,35,-1020,1000)	3.40%
		Annual effective rate =(1.034^2)-1=	6.92%
	Cb	After Tax Cost of Bond =6.92*(1-Tax Rate)=6.92*(1-0.32)=	4.70%
		Preference shares
		Annual Dividend=	$10.00
		Market Value=$105
		Annual required return=10/105=	0.0952
		Required Annual return =	9.52%
	Cp	Cost of Preference Shares=1.2/20=	9.52%
		Common Shares:
		CAPM EQUATION:
		Rs=Rf+Beta*(Rm-Rf)
		Rf=riskfree rate=3.5%, Rm-Rf=Market risk Premium=5.5%, Beta=2.08
		Rs=3.5+2.08*5.5=	14.94%
	Ce	Cost of Equity =14.94%	14.94%
		MARKET VALUE
	A	Market value of bond=4000*1020	$4,080,000
	B	Market Value of preference Shares=10000*105	$1,050,000
	C	Market Value of Ordinary shares=84000 *$56	$4,704,000
	D	Total Market value of capital	$9,834,000
	Wb=A/D	Wb=Weight of Bond in the total capital	0.41
	Wp=B/D	Wp=Weight of Preference Shares in the total capital	0.11
	We=C/D	We=Weight of Common Shares in the total capital	0.48
		After Tax Weighted average Cost of Capital:
		WACC=Wb*Cb+Wp*Cp+We*Ce=0.41*4.7+0.11*9.52+0.48*14.94=	10.11%
		Appropriate Discount Rate=10.1+2.1=	12.20%