National Electric Company (NEC) is considering a $45.19 million project in its p

Question

National Electric Company (NEC) is considering a $45.19 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 $3.29 million per year in perpetuity. Mr. Edison has devised two possibilities for raising the initial investment: Issuing 10-year bonds or issuing common stock. The company's pretax cost of debt is 8.8 percent, and its cost of equity is 12.7 percent. The company's target debt-to-value ratio is 85 percent. The project has the same risk as the company's existing businesses, and it will support the same amount of debt. The tax rate is 34 percent. Calculate the weighted average cost of capital. (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Weighted average cost of capital % Calculate the net present value of the project. (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to 2 decimal places, e.g. 32.16.) Net present value eBook & Resources

Explanation / Answer

Solution :- i). Calculation of Weighted average cost of capital in the given question :-

Weighted average cost of capital = Weight of debt * Cost of debt (after-tax) + Weight of equity * Cost of equity.

= 0.85 * 8.8 % * (1 - 0.34) + (1 - 0.85) * 12.7 %

= 0.85 * 5.808 % + 0.15 * 12.7 %

= 4.9368 % + 1.905 %

= 6.8418 % (Rounded off to 6.84 %)

Conclusion :- Weighted average cost of capital = 6.84 %

ii). Calculation of Net present value (NPV) of Project in the given question :-

Net present value (NPV) = Present value of cash inflows - Present value of cash outflow.

= (3.29 Million / 0.0684) - 45.19 Million

= 48.099 Million - 45.19 Million

= $ 2.909 Million i.e., $ 2909000 (approx).

Yes, The project should be accepted because the net present value (NPV) of project is positive.

Conclusion :- Net present value (NPV) of Project = $ 2909000 (approx).

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