Question

1. Special Financing Example

P Corp. has WACC of 12%. The corporate tax rate is 38%. The company can borrow at an interest rate of 10%. The company is considering a new plant that would cost $8 million and generate year end operating cash flows of $1 million after tax. The plant would have the same risk as the company’s other assets and would have a 20 year life.

a)Should P Corp. proceed with the new plant?

b)If the community is willing to provide a $6 million loan with the 6% interest and entire principal due in 10 years, would your advice change?

Answer 1

a) NPV =Intial investment+ Value of Annuity

Value of Annuity= (C/r) * (1- (1/(1+r)^n)) where C =$1 millions is cash flow r is WACC=12% and n=20 is life of plant

= (1/.12)* (1- (1/(1+0.12)^20)) = $ 7.47 million

NPV= -$8 million +7.47 million = -0.53 million

SInce NPV of the project is -ve so P corp should not take new plant

b) Since the community loan will not affect the WACC of the company, it should not take this project.

Note: Incase of any doubt, please do comment. I will get back to you. Thanks!!