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Consider the following information on Huntington Power Co. Debt: 4,000, 7% semiannual coupon bonds outstanding, $1,000...

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%

1) Calculate project A’s cash flows for years 0-5

2) Calculate NPV, IRR and PI for project A

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

4) Calculate NPV, IRR and PI for project B

5) Which project should be accepted if any and why?

6) What is the exact NPV profile’s crossover rate (incremental IRR)?

Solutions

Expert Solution

1] COMPONENT COST OF CAPITAL:
Cost of debt:
Before tax cost = YTM of the bonds
YTM of the bonds [using a calculator] = 6.81%
After tax cost of debt = YTM*(1-t) = 6.81%*(1-32%) = 4.63%
Cost of preferred stock:
= Dividend/Price = 10/105 = 9.52%
Cost of equity:
Per CAPM, cost of equity = risk free rate+beta*market risk premium.
= 3.5%+2.08*5.5% = 14.94%
WACC:
WACC is the weighted average of the cost of the
components of the capital structure, the weights
being the proportion in which the components are
present in the capital structure. Here, the market
value weights are to be used.
WACC is calculated in the table below:
COMPONENT MARKET VALUE WEIGHT COMPONENT COST WACC
Debt [4000*1020] $        40,80,000 41.49% 4.63% 1.92%
Preferred stock [10000*105] $        10,50,000 10.68% 9.52% 1.02%
Common stock [84000*56] $        47,04,000 47.83% 14.94% 7.15%
Total $        98,34,000 100.00% 10.08%
WACC = 10.08%
2] Discount rate = 10.08%+2.1% = 12.18%
3] PROJECT A:
The cash flows and calculations are done in the table below:
0 1 2 3 4 5
Capital expenditure $        24,00,000
Investment in NWC $          2,85,000
Sales $ 20,50,000 $       20,50,000 $   20,50,000 $   20,50,000 $   20,50,000
Operating costs $    9,50,000 $         9,50,000 $      9,50,000 $     9,50,000 $     9,50,000
Depreciation rate [%] 20.00% 32.00% 19.20% 11.52% 11.52% 5.76%
Depreciation $    4,80,000 $         7,68,000 $      4,60,800 $     2,76,480 $     2,76,480 $     1,38,240
NOI $    6,20,000 $         3,32,000 $      6,39,200 $     8,23,520 $     8,23,520
Tax at 32% $    1,98,400 $         1,06,240 $      2,04,544 $     2,63,526 $     2,63,526
NOPAT $    4,21,600 $         2,25,760 $      4,34,656 $     5,59,994 $     5,59,994
Add: Depreciation $    4,80,000 $         7,68,000 $      4,60,800 $     2,76,480 $     2,76,480
OCF $    9,01,600 $         9,93,760 $      8,95,456 $     8,36,474 $     8,36,474
Recapture of NWC $     2,85,000
After tax salvage value = 225000-(225000-138240)*32% = $     1,97,237
FCF [Cash flows] $      -26,85,000 $    9,01,600 $         9,93,760 $      8,95,456 $     8,36,474 $   13,18,710
PVIF at 12.18% [PVIF = 1/1.1218^t] 1 0.89142 0.79464 0.70836 0.63145 0.56289
PV at 12.18% $      -26,85,000 $    8,03,708 $         7,89,679 $      6,34,305 $     5,28,190 $     7,42,288
4] NPV $          8,13,170
PI = Sum of cash inflows/Initial investment = (2685000+813170)/2685000 = 1.30
IRR:
IRR is that discount rate for which NPV = 0. It has to be found out by trying different discount rates [by trial and error] so that 0 NPV results.
Discounting with 23%:
PVIFA at 23% 1 0.81301 0.66098 0.53738 0.43690 0.35520
PV $      -26,85,000 $    7,33,008 $         6,56,858 $      4,81,204 $     3,65,453 $     4,68,408 $        19,930
Discounting with 24%:
PVIFA at 24% 1 0.80645 0.65036 0.52449 0.42297 0.34111
PV $      -26,85,000 $    7,27,097 $         6,46,306 $      4,69,655 $     3,53,806 $     4,49,822 $       -38,313
IRR = 23%+1%*19930/(19930+38313) = 23.34%
PROJECT B:
5] The cash flows and calculations are done in the table below:
0 1 2 3 4 5
Capital expenditure $        10,00,000
Investment in NWC $          1,50,000
Sales $    9,20,000 $         9,20,000 $      9,20,000 $     9,20,000 $     9,20,000
COGS and operating expenses [25% of sales] $    2,30,000 $         2,30,000 $      2,30,000 $     2,30,000 $     2,30,000
Depreciation [1000000/4] $    2,50,000 $         2,50,000 $      2,50,000 $     2,50,000 $                  -   $                  -  
NOI $    4,40,000 $         4,40,000 $      4,40,000 $     4,40,000 $     6,90,000
Tax at 32% $    1,40,800 $         1,40,800 $      1,40,800 $     1,40,800 $     2,20,800
NOPAT $    2,99,200 $         2,99,200 $      2,99,200 $     2,99,200 $     4,69,200
Add: Depreciation $    2,50,000 $         2,50,000 $      2,50,000 $     2,50,000 $                  -  
OCF $    5,49,200 $         5,49,200 $      5,49,200 $     5,49,200 $     4,69,200
Recapture of NWC $     1,50,000
After tax salvage value = 120000*(1-32%) = $         81,600
FCF $      -11,50,000 $    5,49,200 $         5,49,200 $      5,49,200 $     5,49,200 $     7,00,800
PVIF at 12.18% [PVIF = 1/1.1218^t] 1 0.89142 0.79464 0.70836 0.63145 0.56289
PV at 12.18% $      -11,50,000 $    4,89,570 $         4,36,415 $      3,89,031 $     3,46,792 $     3,94,473
6] NPV $          9,06,281
PI = Sum of cash inflows/Initial investment = (1150000+906281)/1150000 = 1.79

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