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%

Please show your work.

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

2. Calculate project A’s cash flows for years 0-5

Answer 1

MV of equity=Price of equity*number of shares outstanding

MV of equity=56*84000

=4704000

MV of Bond=Par value*bonds outstanding*%age of par

MV of Bond=1000*4000*1.02

=4080000

MV of Preferred equity=Price*number of shares outstanding

MV of Preferred equity=105*10000

=1050000

MV of firm = MV of Equity + MV of Bond+ MV of Preferred equity

=4704000+4080000+1050000

=9834000

Weight of equity = MV of Equity/MV of firm

Weight of equity = 4704000/9834000

W(E)=0.4783

Weight of debt = MV of Bond/MV of firm

Weight of debt = 4080000/9834000

W(D)=0.4149

Weight of preferred equity = MV of preferred equity/MV of firm

Weight of preferred equity = 1050000/9834000

W(PE)=0.1068

Cost of equity

As per CAPM

Cost of equity = risk-free rate + beta * (Market risk premium)

Cost of equity% = 3.5 + 2.08 * (5.5)

Cost of equity% = 14.94

Cost of debt

K = Nx2

Bond Price =∑ [(Semi Annual Coupon)/(1 + YTM/2)^k]     +   Par value/(1 + YTM/2)^Nx2

k=1

K =18x2

1020 =∑ [(7*1000/200)/(1 + YTM/200)^k]     +   1000/(1 + YTM/200)^18x2

k=1

YTM = 6.8056086296

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 6.8056086296*(1-0.32)

= 4.627813868128

cost of preferred equity

cost of preferred equity = Preferred dividend/price*100

cost of preferred equity = 10/(105)*100

=9.52

WACC=after tax cost of debt*W(D)+cost of equity*W(E)+Cost of preferred equity*W(PE)

WACC=4.63*0.4149+14.94*0.4783+9.52*0.1068

WACC =10.08%

Discount rate for the project = WACC+adj. factor = 10.08+2.1=12.18%

Time line		0	1	2	3	4	5
Cost of new machine		-2400000
Initial working capital		-285000
=Initial Investment outlay		-2685000
5 years MACR rate			20.00%	32.00%	19.20%	11.52%	11.52%	5.76%
Sales			2050000	2050000	2050000	2050000	2050000
Profits	Sales-variable cost		1100000	1100000	1100000	1100000	1100000
-Depreciation	=Cost of machine*MACR%		-480000	-768000	-460800	-276480	-276480	138240	=Salvage Value
=Pretax cash flows			620000	332000	639200	823520	823520
-taxes	=(Pretax cash flows)*(1-tax)		421600	225760	434656	559993.6	559993.6
+Depreciation			480000	768000	460800	276480	276480
=after tax operating cash flow			901600	993760	895456	836473.6	836473.6
reversal of working capital							285000
+Proceeds from sale of equipment after tax	=selling price* ( 1 -tax rate)						153000
+Tax shield on salvage book value	=Salvage value * tax rate						44236.8
=Terminal year after tax cash flows							482236.8
Total Cash flow for the period		-2685000	901600	993760	895456	836473.6	1318710.4