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%

1. Calculate WACC for the firm.
2. What is the appropriate discount rate for project A and project B (Risk adjusted rate)?
3. Calculate project A’s cash flows for years 0-5
4. Calculate NPV, IRR and PI for project A
5. Calculate project B’s cash flows for year 0-5
6. Calculate NPV, IRR and PI for project B
7. Which project should be accepted if any and why?
8. What is the exact NPV profile’s crossover rate (incremental IRR)?

Answer 1

A. CALCULATION OF WACC
PARTICULARS	CALCULATION	AMOUNT	WEIGHT	COST	FORMULA	CALCULATION	WEIGHTED COST = WEIGHTS*COST
Debt	=4000*(1000*102%)	40,80,000	0.41	4.76	INTEREST (1-TAX RATE)	=7*(1-0.32)	1.97
Prefered Stock	=10000*105	10,50,000	0.11	10	DIVIDEND/PAR VALUE	=10/100*100	1.07
Common Stock	=84000*56	47,04,000	0.48	14.94	RISKFREE RATE + BETA(MARKET RISK PREMIUM)	=3.5+2.08*(5.5)	7.15
TOTAL		98,34,000	1.00		WACC		10.19

B.  CALCULATION OF APPROPRIATE DISCOUNT RATE:

1. Given that both the projects are exclusive projects. Also, an adjustment factor of +2.1% is given as a risk adjustment factor.

2. Hence, appropriate discount rate = WACC + Adjustment factor = 10.19% + 2.1% = 12.29%

C. CALCULATION OF CASH FLOWS, NPV, AND IRR OF PROJECT A

	YEARS	1-5
A	SALES	20,50,000
B	COSTS	9,50,000
C	PROFIT (A-B)	11,00,000
D	DEPRECIATION = (2.4M-225000)/5 years	4,35,000
E	PROFIT BEFORE TAX(C-D)	6,65,000
F	TAX @ 32%	2,12,800
G	NET INCOME (E-F)	4,52,200
H	CAPITAL EXPENDITURES	2,85,000
I	DEPRECIATION	4,35,000
J	CASH FLOW (G-H+I)	6,02,200
K	PRESENT VALUE ANNUITY FACTOR (5years, 10.19%)	3.772
L	PRESENT VALUE OF CASH FLOWS FROM THE PROJECT	22,71,774
M	TERMINAL VALUE OF THE PROJECT
	= CASH FLOWS OF YEAR 6 /WACC * PRESENT VALUE FACTOR
	= 602200/10.19% * 0.61558
	=3637902
N	PRESENT VALUE OF THE PROJECT (L+M)	59,09,676
O	INITIAL INVESTMENT	-24,00,000
P	NET PRESENT VALUE (NPV = N + O)	35,09,676
	DECISION TO ACCEPT THE PROJECT	ACCEPT

CALCULATION OF IRR for Project A

IRR is the discount rate that makes the Present Value of the expected future cash flows to be equal to the initial investment.

IRR is a discount rate for NPV equal to zero. Hence, we need to use the following formula:

0 = -C₀ + ∑ [Cᵢ / (1 + IRR)ⁱ], where i = 1...n

2400000 = ∑ [602200/ (1 + IRR)ⁱ], where i = 1,2,3,4,5

By solving the above, we get IRR = 8.07%

D. CALCULATION OF CASH FLOWS, NPV, AND IRR OF PROJECT B

	YEARS	1-5
A	SALES	9,20,000
B	COSTS	2,30,000
C	PROFIT (A-B)	6,90,000
D	DEPRECIATION = (1.0M-120000)/4 years	2,20,000
E	PROFIT BEFORE TAX(C-D)	4,70,000
F	TAX @ 32%	1,50,400
G	NET INCOME (E-F)	3,19,600
H	CAPITAL EXPENDITURES	1,50,000
I	DEPRECIATION	2,20,000
J	CASH FLOW (G-H+I)	3,89,600
K	PRESENT VALUE ANNUITY FACTOR (5years, 10.19%)	3.772
L	PRESENT VALUE OF CASHFLOWS FROM THE PROJECT	14,69,750
M	TERMINAL VALUE OF THE PROJECT	-
N	PRESENT VALUE OF THE PROJECT (L+M)	14,69,750
O	INITIAL INVESTMENT	-10,00,000
P	NET PRESENT VALUE (NPV = N + O)	4,69,750
	DECISION TO ACCEPT THE PROJECT	ACCEPT

CALCULATION OF IRR for Project B

IRR is a discount rate for NPV equal to zero. Hence, we need to use the following formula:

0 = -C₀ + ∑ [Cᵢ / (1 + IRR)ⁱ], where i = 1...n

1000000 = ∑ [389600/ (1 + IRR)ⁱ], where i = 1,2,3,4,5

By solving the above, we get IRR = 27.31%

E. DECISION

Both project A and B have positive NPV which results in a conflict with regard to decision making. In such cases, IRR provides a clear picture.

As seen above, for project A, IRR = 8.07% whereas, for project B, IRR = 27.31%.

Thus project B shall be accepted as it has a higher Rate of return when compared to Project A.