and the market risk premium is &pervenLat; suvt 6. Westcon is considering buildi

Question

and the market risk premium is &pervenLat; suvt 6. Westcon is considering building a facility to tap thermal energy using wind power. Parto the project's cost, $750,000, can be financed with a loan from the l'ederal Energy Commission at the below-markct rate of 5 percent. The remainder , $250,000, can be financed ith an industrial revenue bond at 10 percent. No debt is being displaced. Current debt rates for Westcon are 15 percent. The project should generate before tax cash flows of $1,500,000 per year for ten years. Westcon has a 40 percent tax rate, and the D/E ratio is.50. Westcon estimates that the project beta is 1.50 and forecasts a risk-free rate of 10 percent for the life of the project. The return on the market is estimated to be 20 percent. a. Should Westcon undertake the project? b. Assuming the project is of the same risk as Westcon itself, would the project be acceptable without the subsidies? Explain

Explanation / Answer

a. Ofcourse, project seems to be too attractive: post tax cash flow = (1500000*(1-40%))

b. Now, the project is as risky as the company itself, it means the cost of capital debt ratios etc are same:

Project cost of capital needs to be calculated and the cash flows will be discounted at the same rate:

Ce = 10 + 1.5*(20-10) = 25%

Cd = 15%*(1-0.4) = 9%

WACC = 9%*0.5 + 25%*0.5 = 17%

Project IRR >> WACC,

So company can still take the project without subsidies.

Capital cost Fed loan 500000 5% Ind bond 250000 10.00% 0 1 2 3 4 5 6 7 8 9 10 -750000 900000 900000 900000 900000 900000 900000 900000 900000 900000 900000 Cost of capital 6.667% NoProject IRR 120%

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