Question

National Electric Company (NEC) is considering a $45.06 million project in its power systems division. Tom Edison, the company’s chief financial officer, has evaluated the project and determined that the project’s unlevered cash flows will be $3.16 million per year in perpetuity. Mr. Edison has devised two possibilities for raising the initial investment: Issuing 10-year bonds or issuing common stock. The company’s pretax cost of debt is 7.5 percent, and its cost of equity is 11.4 percent. The company’s target debt-to-value ratio is 85 percent. The project has the same risk as the company’s existing businesses, and it will support the same amount of debt. The tax rate is 35 percent.

  

Calculate the weighted average cost of capital. (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

  

Weighted average cost of capital

%

  

Calculate the net present value of the project. (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

  

Net present value

$

  

Answer 1

Wieghted average cost of capital =

[ (15%×11.4%) + (85%× 4.87%) ]

=5.85%

Note.

1) please find an tabular calculation for your understanding .

2) in question they said that company target debt proportion is 85% , so proportion of equity is (100%-85%)

3) in case of cost of debt they given pre tax, we post tax rate in calculation .

So post tax is 7.5% ×65%

Net present value.

  Note.

1) initial investment is a cash ouflow , so it is shown as negative and cash inflow is shown has possitive.

2) for finding net present value we use discounted cashflows

- Discounted value for initial investment is (1×45.06m), always remember that discounting facter for y0 is 1

- in case of cash in flow , question says that cashflow happends perpectualy , it means this cash flow have infinite lifetime and will continue for forseable future

So , present value = cashflow / Wacc

=$3.16 m / 6%

= $52.67

Our wacc is 5.87% , it is rounded to 6%