Carter & Carter (C&C) is considering a project that requires an initial cash out

Question

Carter & Carter (C&C) is considering a project that requires an initial cash outlay for equipment of $6.3 million. The equipment will be depreciated to a zero book value over the 4-year life of the project. At the end of the project, C&C expects to sell the equipment for $1 million. The project will produce cash inflows of $1.5 million a year for the first 2 years and $2.2 million a year for the following 2 years. C&C has a cost of equity of 12 percent and a pre-tax cost of debt of 8 percent. The debt-equity ratio is .75 and the tax rate is 35 percent.

1. What is the company’s WACC?

2. At the company’s WACC (as computed in part a), what is the NPV of the project?

3. If the company has decided that they will accept the project if the project’s internal rate of return (IRR) exceeds the firm’s weighted average cost of capital (WACC) by 2 percent or more, should the project be considered (i.e. accepted)?

Explanation / Answer

a) Cost of Debt (Kd) = 8 x (1 -0.35) = 5.2%
WACC = (12% x 1/1.75) + (5.2 x 0.75/1.75) = 9.09% ...(Since Debt-Equity = 0.75:1)

(b) Annual Depreciation = 6.3/4 = $1.575 million per year
Annual Cash Flows:
Year 1 = (1.5 - 1.575) x (1 - 0.35) + 1.575 = $1,526,250
Year 2 = (1.5 - 1.575) x (1 - 0.35) + 1.575 = $1,526,250
Year 3 = (2.2 - 1.575) x (1 - 0.35) + 1.575 = $1,981,250
Year 4 = (2.2 - 1.575) x (1 - 0.35) + 1.575 = $1,981,250
Year 4 = $1,000,000
NPV at WACC = -6,300,000 + 1,526,250/(1.0909)1 + 1,526,250/(1.0909)2 + 1,981,250/(1.0909)3 + 1,981,250/(1.0909)4 + 1,000,000/(1.0909)4 = $12,706.28

(c) For IRR we need two discount rates, one on which NPV is positive and one on which NPV is negative. For finding these two discount rates we will use Trial and Error method.
IRR = Lower rate + NPV at Lower Rate x (Higher Rate - Lower Rate)/(NPV at Lower Rate - NPV at Higher Rate)
If we look at 9.5%, NPV = -$50,547.59, and if we look at 9%, NPV = $26,724.63
IRR = 9% + 26,724.63 x (9.50 - 9.00) / [26,724.63 - (-50,547.59)] = 9.17%

Since, IRR is not exceeding firm's WACC by 2%, thus, the project should not be accepted.

Related Questions

Navigate

• Browse (All)
• Browse C
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.