Question

# National Electric Company (NEC) is considering a \$45.2 million project in its power systems division. Tom...

National Electric Company (NEC) is considering a \$45.2 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 \$3.3 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 8.9 percent, and its cost of equity is 12.8 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 40 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 \$

ANSWER: WACC = 6.46% and NPV = \$5,883,591.33

Cash outflow = \$45,200,000

Earnings per year = \$3,300,000

Tax rate = 40%

Before-tax cost of debt = 8.9%

After-tax cost of debt = (1 - Tax) x Before-tax cost of debt = (1 - 0.4) x 8.9% = 5.34%

Cost of equity = 12.8%

Debt-to-value ratio = 85% (This means that the weight of debt in total capital is 85% and that of equity is 15%.)

Computation of WACC -

WACC = (Weight of debt x After-tax cost of debt) + (Weight of equity x Cost of equity)

= (0.85 x 5.34%) + (0.15 x 12.8%)

= 4.539% + 1.92%

= 6.459%

= 6.46%

Computation of NPV -

NPV = Present value of cash inflows - Present value of cash outflows

= (Earnings / WACC) - Present value of cash outflows

= (3,300,000 / 6.46%) - 45,200,000

= 51,083,591.3312 - 45,200,000

= 5,883,591.3312

= \$5,883,591.33