Question 11 - JustAnswer



Question 11

Finding the WACC Given the following information for Huntington Power Co., find the WACC. Assume the company’s tax rate is 35 percent.

Debt: 4,000 7 percent coupon bonds outstanding, $1,000 par value, 20 years to maturity, selling for 103 percent of par; the bonds make semiannual payments.

Common stock: 90,000 shares outstanding, selling for $57 per share; the beta is 1.10.

Market: 8 percent market risk premium and 6 percent risk-free rate.

First: find the market value of each type of financing:

MVD = 4,000($1,000)(1.03) = $4,120,000

MVE = 90,000($57) = $5,130,000

And the total market value of the firm is:

V = $4,120,000 + 5,130,000 = $9,250,000

Now, we can find the cost of equity using the CAPM. The cost of equity is:

RE = .06 + 1.10(.08) = .1480 or 14.80%

The cost of debt is the YTM of the bonds, so:

P0 = $1,030 = $35(PVIFAR%,40) + $1,000(PVIFR%,40)

R = 3.36%

YTM = 3.36% × 2 = 6.72%

And the aftertax cost of debt is:

RD = (1 – .35)(.0672) = .0437 or 4.37%

Now we have all of the components to calculate the WACC. The WACC is:

WACC = .0437(4.12/9.25) + .1480(5.13/9.25) = .1015 or 10.15%

Notice that we didn’t include the (1 – tC) term in the WACC equation. We simply used the aftertax cost of debt in the equation, so the term is not needed here.

P.S. I have also answered the questions on the attached excel sheet template from the book’s website.

Question 14

WACC and NPV Och, Inc., is considering a project that will result in initial aftertax cash savings of $3.5 million at the end of the first year, and these savings will grow at a rate of 5 percent per year indefinitely. The firm has a target debt-equity ratio of .65, a cost of equity of 15 percent, and an aftertax cost of debt of 5.5 percent. The cost-saving proposal is somewhat riskier than the usual project the firm undertakes; management uses the subjective approach and applies an adjustment factor of +2 percent to the cost of capital for such risky projects. Under what circumstances should Och take on the project?

Using the debt-equity ratio to calculate the WACC, we find:

WACC = (.65/1.65)(.055) + (1/1.65)(.15) = .1126 or 11.26%

Since the project is riskier than the company, we need to adjust the project

discount rate for the additional risk. Using the subjective risk factor given, we

find:

Project discount rate = 11.26% + 2.00% = 13.26%

We would accept the project if the NPV is positive. The NPV is the PV of the cash

outflows plus the PV of the cash inflows. Since we have the costs, we just need to

find the PV of inflows. The cash inflows are a growing perpetuity. If you remember,

the equation for the PV of a growing perpetuity is the same as the dividend growth

equation, so:

PV of future CF = $3,500,000/(.1326 – .05) = $42,385,321

The project should only be undertaken if its cost is less than $42,385,321 since costs

less than this amount will result in a positive NPV.

Question 17

Project Evaluation This is a comprehensive project evaluation problem bringing together much of what you have learned in this and previous chapters. Suppose you have been hired as a financial consultant to Euro Trans Air (ETA), a large, publicly traded firm that is the market share leader in radar detection systems (RDSs). The company is looking at setting up a manufacturing plant overseas to produce a new line of RDSs. This will be a five-year project. The company bought some land three years ago for (??)7 million in anticipation of using it as a toxic dump site for waste chemicals, but it built a piping system to safely discard the chemicals instead. If the company sold the land today, it would receive (??)6.5 million after taxes. In five years, the land can be sold for (??)4.5 million after taxes and reclamation costs. The company wants to build its new manufacturing plant on this land; the plant will cost (??)15 million to build. The following market data on ETA’s securities are current:

Debt:     15,000 7 percent coupon bonds outstanding, 15 years to maturity, selling for 92 percent of par; the bonds have a (??)1,000 par value each and make semiannual payments.

Common stock:     300,000 shares outstanding, selling for (??)75 per share; the beta is 1.3.

Preferred stock: 20,000 shares of 5 percent preferred stock outstanding, selling for (??)72 per share.

Market: 8 percent expected market risk premium; 5 percent risk-free rate.

ETA’s tax rate is 35 percent. The project requires (??)900,000 in initial net working capital investment to get operational.

a.     Calculate the project’s initial Time 0 cash flow, taking into account all side effects.

b.     The new RDS project is somewhat riskier than a typical project for ETA, primarily because the plant is being located overseas. Management has told you to use an adjustment factor of +2 percent to account for this increased riskiness. Calculate the appropriate discount rate to use when evaluating ETA’s project.

c.     The manufacturing plant has an eight-year tax life, and ETA uses straight-line depreciation. At the end of the project (i.e., the end of Year 5), the plant can be scrapped for (??)5 million. What is the aftetax salvage value of this manufacturing plant?

d.     The company will incur (??)400,000 in annual fixed costs. The plan is to manufacture 12,000 RDSs per year and sell them at (??)10,000 per machine; the variable production costs are (??)9,000 per RDS. What is the annual operating cash flow, OCF, from this project?

e.     ETA’s comptroller is primarily interested in the impact of ETA’s investments on the bottom line of reported accounting statements. What will you tell her is the accounting break-even quantity of RDSs sold for this project?

f.     Finally, ETA’s president wants you to throw all your calculations, assumptions, and everything else into the report for the chief financial officer; all he wants to know is what the RDS project’s internal rate of return, IRR, and net present value, NPV, are. What will you report?

Solution to Comprehensive Problem (Question 17)

The $7 million cost of the land 3 years ago is a sunk cost and irrelevant; the $6.5

million appraised value of the land is an opportunity cost and is relevant. The

relevant market value capitalization weights are:

MVD = 15,000($1,000)(0.92) = $13,800,000

MVE = 300,000($75) = $22,500,000

MVP = 20,000($72) = $1,440,000

The total market value of the company is:

V = $13,800,000 + 22,500,000 + 1,440,000 = $37,740,000

Next we need to find the cost of funds. We have the information available to calculate the cost of equity using the CAPM, so:

RE = .05 + 1.3(.08) = .1540 or 15.40%

The cost of debt is the YTM of the company’s outstanding bonds, so:

P0 = $920 = $35(PVIFAR%,30) + $1,000(PVIFR%,30)

R = 3.96%

YTM = 3.96% × 2 = 7.92%

And the aftertax cost of debt is:

RD = (1 – .35)(.0792) = .0515 or 5.15%

The cost of preferred stock is:

RP = $5/$72 = .0694 or 6.94%

a. The initial cost to the company will be the opportunity cost of the land, the cost of the plant, and the net working capital cash flow, so:

CF0 = –$6,500,000 – 15,000,000 – 900,000 = –$22,400,000

b. To find the required return on this project, we first need to calculate the WACC for the company. The company’s WACC is:

WACC = [($22.5/$37.74)(.1540) + ($1.44/$37.74)(.0694) + ($13.8/$37.74)(.0515)] = .1133

The company wants to use the subjective approach to this project because it is located overseas. The adjustment factor is 2 percent, so the required return on this project is:

Project required return = .1133 + .02 = .1333

c. The annual depreciation for the equipment will be:

$15,000,000/8 = $1,875,000

So, the book value of the equipment at the end of five years will be:

BV5 = $15,000,000 – 5($1,875,000) = $5,625,000

So, the aftertax salvage value will be:

Aftertax salvage value = $5,000,000 + .35($5,625,000 – 5,000,000) = $5,218,750

d. Using the tax shield approach, the OCF for this project is:

OCF = [(P – v)Q – FC](1 – t) + tCD

OCF = [($10,000 – 9,000)(12,000) – 400,000](1 – .35) + .35($15M/8) = $8,196,250

e. The accounting breakeven sales figure for this project is:

QA = (FC + D)/(P – v) = ($400,000 + 1,875,000)/($10,000 – 9,000) = 2,275 units

f. We have calculated all cash flows of the project. We just need to make sure that in Year 5 we add back the aftertax salvage value, the recovery of the initial NWC, and the aftertax value of the land. The cash flows for the project are:

Year Flow Cash

0 –$22,400,000

1 8,196,250

2 8,196,250

3 8,196,250

4 8,196,250

5 18,815,000

Using the required return of 13.33 percent, the NPV of the project is:

NPV = –$22,400,000 + $8,196,250(PVIFA13.33%,4) + $18,815,000/1.13335

NPV = $11,878,610.78

And the IRR is:

NPV = 0 = –$22,400,000 + $8,196,250(PVIFAIRR%,4) + $18,815,000/(1 + IRR)5

IRR = 30.87%

................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download