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

Answer 1

Calculation of Project B's cash flow :

Year	0	1	2	3	4	5
Initial investment	-1,000,000
Investment in working capital	-150,000
sales		920000	920000	920000	920000	920000
less:cost of goods sold and operating expense		920000*25%=-230000	-230000	-230000	-230000	-230000
Depreciation expense		-250000	-250000	-250000	-250000	0
Income before tax		440000	440000	440000	440000	690000
less:tax rate		440000*.32=-140800	-140800	-140800	-140800	-220800
Net income		299200	299200	299200	299200	469200
Add:Depreciation		250000	250000	250000	250000	0
After tax sale value of asset						81600
working capital released						150000
Total cash flow	-1150000	549200	549200	549200	549200	700800

**Depreciation expense =cost /useful life

                     = 1000000/4

                   = 250000

After tax sale value = 120000[1-.32]=81600