National Electric Company (NEC) is considering a $45.08 million project in its p

Question

National Electric Company (NEC) is considering a $45.08 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 $3.18 million per year in perpetuity. Mr. Edison has devised two possibilities for raising the initial investment: Issuing 10-year bonds or issuing common stock. NEC’s pretax cost of debt is 7.7 percent, and its cost of equity is 11.6 percent. The company’s target debt-to-value ratio is 80 percent. The project has the same risk as NEC’s existing businesses, and it will support the same amount of debt. NEC is in the 34 percent tax bracket.

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

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

National Electric Company (NEC) is considering a $45.08 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 $3.18 million per year in perpetuity. Mr. Edison has devised two possibilities for raising the initial investment: Issuing 10-year bonds or issuing common stock. NEC’s pretax cost of debt is 7.7 percent, and its cost of equity is 11.6 percent. The company’s target debt-to-value ratio is 80 percent. The project has the same risk as NEC’s existing businesses, and it will support the same amount of debt. NEC is in the 34 percent tax bracket.

Explanation / Answer

NEC Cost of equity = 11.60% Cost of debt 7.70% Tax rate 34% Post tax cost of debt = 5.08% Debt value ratio                              0.80 Required investment=                 45,080,000 Debt =                 36,064,000 Equity =                   9,016,000 WACC=0.80*0.0508+0.20*0.1160= 6.38% So WACC for the project = 6.38% Unlevered cash flow                   3,180,000 Net Income before tax                   4,818,182 Interest on Debt                   2,776,928 EBT                   2,041,254 Post Tax Income                   1,347,228 So levered cash flow per year                   1,347,228 As the cash flow is in perpetuity , PV of cash flows =1347228/6.38% $            21,116,419 Investment = $            45,080,000 NPV = $    (23,963,581.19) Actual result may vary with the given result to you due to difference in discounting factor digits used, Here 4 digit factor used for accuracy.

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