Question

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

Answer 1

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