National Electric Company (NEC) is considering a $45.05 million project in its p

Question

National Electric Company (NEC) is considering a $45.05 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 $3.15 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 7.4 percent, and its cost of equity is 11.3 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 40 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))

  

  Weighted average cost of capital

%

  

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))

  

  Net present value

$   

  

Should NEC accept the project?

National Electric Company (NEC) is considering a $45.05 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 $3.15 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 7.4 percent, and its cost of equity is 11.3 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 40 percent tax bracket.

Explanation / Answer

WACC:-

(NOTE 1) Cost of Debt = 7.4 (1 - 0.40) = 4.44%

WACC = 14.852 / 1.80

= 8.25 % (approx)

Conclusion:-The weighted average cost of capital = 8.25%

Calculation of NPV:-

  P.V. of Cash inflow:- $ 3.15 Milion / 8.25% = $ 38.18 Milion

P.V. of Cash outflow = $ 45.05 Milion

NPV = 38.18 - 45.05 = (-) 6.87 Milion dollars

Conclusion:- The Project should not be accepted as the NPV is negative.

Weight Cost Weight * Cost Debt 0.80 4.44(NOTE 1) 3.552 Equity 1 11.3 11.3 Total 1.80 14.852

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