In: Finance
Peter Johnson, the CFO of Homer Industries, Inc is trying to determine the Weighted Cost of Capital (WACC) based on two different capital structures under consideration to fund a new project. Assume the company’s tax rate is 30%.
Component | Scenario 1 | Scenario 2 | Cost of Capital | Tax Rate |
---|---|---|---|---|
Debt | $4,000,000.00 | $1,000,000.00 | 8% | 30% |
Preferred Stock | 1,200,000.00 | 1,500,000.00 | 10% | |
Common Stock | 1,000,000.00 | 3,700,000.00 | 13% | |
Total | $6,200,000.00 | $6,200,000.00 |
1-a. Complete the table below to determine the WACC for each of the two capital structure scenarios. (Enter your answer as a whole percentage rounded to 2 decimal places (e.g. .3555 should be entered as 35.55).)
1-b. Which capital structure shall Mr. Johnson choose to fund the new project?
Scenario 1
Scenario 2
Part 2
Assume the new project’s operating cash flows for the upcoming 5 years are as follows:
Project A | |
---|---|
Initial Outlay | $ -6,200,000.00 |
Inflow year 1 | 1,270,000.00 |
Inflow year 2 | 1,750,000.00 |
Inflow year 3 | 1,980,000.00 |
Inflow year 4 | 2,160,000.00 |
Inflow year 5 | 2,450,000.00 |
WACC | ? |
2-a. What are the WACC (restated from Part 1), NPV, IRR, and payback years of this project? (Negative values should be entered with a minus sign. All answers should be entered rounded to 2 decimal places. Your answers for WACC and IRR should be whole percentages (e.g. .3555 should be entered as 35.55).)
2-b. Shall the company accept or reject this project based on the outcome using the net present value (NPV) method?
Project A should be accepted
Project A should be rejected
Calculation of NPV | ||||||||
7.65% | ||||||||
Year | Annual Cash flow | PV factor | Present values | |||||
0 | $ (6,200,000) | 1.0000 | $ (6,200,000) | |||||
1 | $ 1,270,000 | 0.9290 | $ 1,179,802 | |||||
2 | $ 1,750,000 | 0.8630 | $ 1,510,251 | |||||
3 | $ 1,980,000 | 0.8017 | $ 1,587,383 | |||||
4 | $ 2,160,000 | 0.7448 | $ 1,608,702 | |||||
5 | $ 2,450,000 | 0.6919 | $ 1,695,093 | |||||
Net Present Value | $ 1,381,231 | |||||||
Since NPV is positive, the proejct should be accepted. | ||||||||
Calculation of IRR | ||||||||
14.00% | 15.00% | |||||||
Year | Total cash flow | PV factor @ 14% | Present values | PV factor @ 15% | Present values | |||
0 | $ (6,200,000) | 1.000 | $ (6,200,000) | 1.000 | $ (6,200,000) | |||
1 | $ 1,270,000 | 0.877 | $ 1,114,035 | 0.870 | $ 1,104,348 | |||
2 | $ 1,750,000 | 0.769 | $ 1,346,568 | 0.756 | $ 1,323,251 | |||
3 | $ 1,980,000 | 0.675 | $ 1,336,444 | 0.658 | $ 1,301,882 | |||
4 | $ 2,160,000 | 0.592 | $ 1,278,893 | 0.572 | $ 1,234,987 | |||
5 | $ 2,450,000 | 0.519 | $ 1,272,453 | 0.497 | $ 1,218,083 | |||
$ 148,393 | $ (17,449) | |||||||
IRR | =Lower rate + Difference in rates*(NPV at lower rate)/(Lower rate NPV-Higher rate NPV) | |||||||
IRR | '=14%+ (15%-14%)*(148393./(148393.-(-17448.) | |||||||
14.89% | ||||||||
Calculation of payback period | ||||||||
Year | Total cash flow | Cumulative cashflow | ||||||
0 | $ (6,200,000) | $ (6,200,000) | ||||||
1 | $ 1,270,000 | $ (4,930,000) | ||||||
2 | $ 1,750,000 | $ (3,180,000) | ||||||
3 | $ 1,980,000 | $ (1,200,000) | ||||||
4 | $ 2,160,000 | $ 960,000 | ||||||
5 | $ 2,450,000 | $ 3,410,000 | ||||||
So cumulative cashflow becomes positive in 4th year | ||||||||
Payback period= | 3+1200000/2160000 | |||||||
Payback period= | 3.56 |