Question 1
Finding the WACC Given the following information for Huntington Power Co., find the WACC. Assume the company’s tax rate is 35 percent.
Debt: 4,000 7 percent coupon bonds outstanding, $1,000 par value, 20 years to maturity, selling for 103 percent of par; the bonds make semiannual payments.
Common stock: 90,000 shares outstanding, selling for $57 per share; the beta is 1.10.
Market: 8 percent market risk premium and 6 percent risk-free rate.
Question 2
Project Evaluation This is a comprehensive project evaluation problem bringing together much of what you have learned in this and previous chapters. Suppose you have been hired as a financial consultant to Euro Trans Air (ETA), a large, publicly traded firm that is the market share leader in radar detection systems (RDSs). The company is looking at setting up a manufacturing plant overseas to produce a new line of RDSs. This will be a five-year project. The company bought some land three years ago for (??)7 million in anticipation of using it as a toxic dump site for waste chemicals, but it built a piping system to safely discard the chemicals instead. If the company sold the land today, it would receive (??)6.5 million after taxes. In five years, the land can be sold for (??)4.5 million after taxes and reclamation costs. The company wants to build its new manufacturing plant on this land; the plant will cost (??)15 million to build. The following market data on ETA’s securities are current:
Debt: 15,000 7 percent coupon bonds outstanding, 15 years to maturity, selling for 92 percent of par; the bonds have a (??)1,000 par value each and make semiannual payments.
Common stock: 300,000 shares outstanding, selling for (??)75 per share; the beta is 1.3.
Preferred stock: 20,000 shares of 5 percent preferred stock outstanding, selling for (??)72 per share.
Market: 8 percent expected market risk premium; 5 percent risk-free rate.
ETA’s tax rate is 35 percent. The project requires (??)900,000 in initial net working capital investment to get operational.
a. Calculate the project’s initial Time 0 cash flow, taking into account all side effects.
b. The new RDS project is somewhat riskier than a typical project for ETA, primarily because the plant is being located overseas. Management has told you to use an adjustment factor of +2 percent to account for this increased riskiness. Calculate the appropriate discount rate to use when evaluating ETA’s project.
c. The manufacturing plant has an eight-year tax life, and ETA uses straight-line depreciation. At the end of the project (i.e., the end of Year 5), the plant can be scrapped for (??)5 million. What is the aftetax salvage value of this manufacturing plant?
d. The company will incur (??)400,000 in annual fixed costs. The plan is to manufacture 12,000 RDSs per year and sell them at (??)10,000 per machine; the variable production costs are (??)9,000 per RDS. What is the annual operating cash flow, OCF, from this project?
e. ETA’s comptroller is primarily interested in the impact of ETA’s investments on the bottom line of reported accounting statements. What will you tell her is the accounting break-even quantity of RDSs sold for this project?
f. Finally, ETA’s president wants you to throw all your calculations, assumptions, and everything else into the report for the chief financial officer; all he wants to know is what the RDS project’s internal rate of return, IRR, and net present value, NPV, are. What will you report?
Debt: 15,000 7 percent coupon bonds outstanding, 15 years to maturity, selling for 92 percent of par; the bonds have a (??)1,000 par value each and make semiannual payments.
Common stock: 300,000 shares outstanding, selling for (??)75 per share; the beta is 1.3.
Preferred stock: 20,000 shares of 5 percent preferred stock outstanding, selling for (??)72 per share.
Market: 8 percent expected market risk premium; 5 percent risk-free rate.
ETA’s tax rate is 35 percent. The project requires (??)900,000 in initial net working capital investment to get operational.
a. Calculate the project’s initial Time 0 cash flow, taking into account all side effects.
b. The new RDS project is somewhat riskier than a typical project for ETA, primarily because the plant is being located overseas. Management has told you to use an adjustment factor of +2 percent to account for this increased riskiness. Calculate the appropriate discount rate to use when evaluating ETA’s project.
c. The manufacturing plant has an eight-year tax life, and ETA uses straight-line depreciation. At the end of the project (i.e., the end of Year 5), the plant can be scrapped for (??)5 million. What is the aftetax salvage value of this manufacturing plant?
d. The company will incur (??)400,000 in annual fixed costs. The plan is to manufacture 12,000 RDSs per year and sell them at (??)10,000 per machine; the variable production costs are (??)9,000 per RDS. What is the annual operating cash flow, OCF, from this project?
e. ETA’s comptroller is primarily interested in the impact of ETA’s investments on the bottom line of reported accounting statements. What will you tell her is the accounting break-even quantity of RDSs sold for this project?
f. Finally, ETA’s president wants you to throw all your calculations, assumptions, and everything else into the report for the chief financial officer; all he wants to know is what the RDS project’s internal rate of return, IRR, and net present value, NPV, are. What will you report?
Question 3
WACC and NPV Och, Inc., is considering a project that will result in initial aftertax cash savings of $3.5 million at the end of the first year, and these savings will grow at a rate of 5 percent per year indefinitely. The firm has a target debt-equity ratio of .65, a cost of equity of 15 percent, and an aftertax cost of debt of 5.5 percent. The cost-saving proposal is somewhat riskier than the usual project the firm undertakes; management uses the subjective approach and applies an adjustment factor of +2 percent to the cost of capital for such risky projects. Under what circumstances should Och take on the project?
