North Sea Oil has compiled the following data relative to current costs of its b
ID: 2735431 • Letter: N
Question
North Sea Oil has compiled the following data relative to current costs of its basic sources of external capitals, long-term debt, preferred stock, and common stock equiy. Source of capital Cost Long-Term Debt 7% Preffered Stock 19% Common Stock and Retained Earnings 20% Below are the company's target capital structure proportion used in calculating the weighted average cost of capital.
Source of Capital Target Capital Structure Long Term Debt .25 Preferred Stock .25 Common Stock and Retained Earning .50 North Sea has the opportunity to invest in the following projects:
Project A Project B
Initial Investment $130,000 $85,000
Year Cash inflows Cash inflows
1 $25,000 $40,000
2 $35,000 $35000
3 $45,000 $30,000
4 $50,000 $10,000
5 $55,000 $5,000
Using the WACC to calculate the NPV and evaluate the IRR, which project should be implemented? (you may also wish to include payback to further support your answer). Assuming the project(s) is implemented using equity financing, the capital structure changes to: Source of Capital New capital structure after project implementation Long term debt .20 Preferred stock .20 Common stock and retained earnings .60 Calculate the New WACC and briefly discuss in your report if this new WACC and capital structure might signal the market and investors
Explanation / Answer
WACC = cost of long term debt*it's weight + cost of preferred stock*it's weight + cost of equity*it's weight = 7%*0.25 + 19%*0.25 + 20%*0.5 = 16.5%.
NPV = sum of all present values. present value = cash flow*discount factor. discount factor = 1/(1+WACC)^t where WACC = 16.5% and t = the year in which cash flow takes place. for example discount factor for year 2 = 1/1.165^2 = 0.7368. pv of project A's cash flow = 35,000*0.7638 = 25,787.9128
NPV calculation table:
NPV is positive for Project B as well as higher than project A's NPV and hence it will be implemented under the NPV criteria.
IRR: It is the rate which makes the NPV as nil. This has to be calculated using a trial and error method.
Thus IRR for A = 1.16055770 - 1 = 16.05577%
IRR of B:
Thus B's IRR is 17.7498%. B's IRR is greater than A's IRR and hence as per the IRR criteria B will be selected.
New WACC = 0.20*7% + 0.20*19% + 0.60*20% = 17.2%. It means that the WACC has increased. Earlier it was 16.5%. It means that the rate has increased by 17.2% - 16.5% = 0.7% or 70 basis points. As the discounting rate has increased, it means that risk associated with the projects have increased and this has resulted in higher discounting through a higher WACC.
Year Cash flow of Project A Cash flow of Project B Discount factor PV of A PV of B 0 -130,000.00 -85,000.00 1.00 -130,000.00 -85,000.00 1 25,000.00 40,000.00 0.86 21,459.23 34,334.76 2 35,000.00 35,000.00 0.74 25,787.91 25,787.91 3 45,000.00 30,000.00 0.63 28,459.99 18,973.33 4 50,000.00 10,000.00 0.54 27,143.53 5,428.71 5 55,000.00 5,000.00 0.47 25,629.08 2,329.92 NPV -1,520.26 1,854.63Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.