Consider the following information on Huntington Power Co. Debt: 4,000, 7% semiannual coupon bonds outstanding, $1,000 par...

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Finance

Consider the following information on Huntington Power Co.Debt:
4,000, 7% semiannual coupon bonds outstanding, $1,000 par value,18 years to maturity, selling for 102 percent of par; the bondsmake semiannual payments. Preferred Stock: 10,000 outstanding withpar value of $100 and a market value of 105 and $10 annualdividend. Common Stock: 84,000 shares outstanding, selling for $56per share, the beta is 2.08
The market risk premium is 5.5%, the risk free rate is 3.5% andHuntington’s tax rate is 32%.
Huntington Power Co. is evaluating two mutually exclusiveproject that is somewhat riskier than the usual project the firmundertakes; management uses the subjective approach and decided toapply an adjustment factor of +2.1% to the cost of capital for bothprojects.
Project A is a five-year project that requires an initial fixedasset investment of $2.4 million. The fixed asset falls into thefive-year MACRS class. The project is estimated to generate$2,050,000 in annual sales, with costs of $950,000. The projectrequires an initial investment in net working capital of $285,000and the fixed asset will have a market value of $225,000 at the endof five years when the project is terminated.
Project B requires an initial fixed asset investment of $1.0million. The marketing department predicts that sales related tothe project will be $920,000 per year for the next five years,after which the market will cease to exist. The machine will bedepreciated down to zero over four-year using the straight-linemethod (depreciable life 4 years while economic life 5 years). Costof goods sold and operating expenses related to the project arepredicted to be 25 percent of sales. The project will also requirean addition to net working capital of $150,000 immediately. Theasset is expected to have a market value of $120,000 at the end offive years when the project is terminated.
Use the following rates for 5-year MACRS: 20%, 32%, 19.2%,11.52%, 11.52%, and 5.76%
1) Calculate project A’s cash flows for years 0-5
2) Calculate NPV, IRR and PI for project A
3) Calculate project B’s cash flows for year 0-5
4) Calculate NPV, IRR and PI for project B
5) Which project should be accepted if any and why?
6) What is the exact NPV profile’s crossover rate (incrementalIRR)?

Answer & Explanation Solved by verified expert

4.3 Ratings (821 Votes)

1 COMPONENT COST OF CAPITAL Cost of debt Before tax cost YTM of the bonds YTM of the bonds using a calculator 681 After tax cost of debt YTM1t 681132 463 Cost of preferred stock DividendPrice 10105 952 Cost of equity Per CAPM cost of equity risk free ratebetamarket risk premium 3520855 1494 WACC WACC is the weighted average of the cost of the components of the capital structure the weights being the proportion in which the components are present in the capital structure Here the market value weights are to be used WACC is calculated in the table below COMPONENT MARKET VALUE See Answer

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Consider the following information on Huntington Power Co.Debt:4,000, 7% semiannual coupon bonds outstanding, $1,000 par value,18 years to maturity, selling for 102 percent of par; the bondsmake semiannual payments. Preferred Stock: 10,000 outstanding withpar value of $100 and a market value of 105 and $10 annualdividend. Common Stock: 84,000 shares outstanding, selling for $56per share, the beta is 2.08The market risk premium is 5.5%, the risk free rate is 3.5% andHuntington’s tax rate is 32%.Huntington Power Co. is evaluating two mutually exclusiveproject that is somewhat riskier than the usual project the firmundertakes; management uses the subjective approach and decided toapply an adjustment factor of +2.1% to the cost of capital for bothprojects.Project A is a five-year project that requires an initial fixedasset investment of $2.4 million. The fixed asset falls into thefive-year MACRS class. The project is estimated to generate$2,050,000 in annual sales, with costs of $950,000. The projectrequires an initial investment in net working capital of $285,000and the fixed asset will have a market value of $225,000 at the endof five years when the project is terminated.Project B requires an initial fixed asset investment of $1.0million. The marketing department predicts that sales related tothe project will be $920,000 per year for the next five years,after which the market will cease to exist. The machine will bedepreciated down to zero over four-year using the straight-linemethod (depreciable life 4 years while economic life 5 years). Costof goods sold and operating expenses related to the project arepredicted to be 25 percent of sales. The project will also requirean addition to net working capital of $150,000 immediately. Theasset is expected to have a market value of $120,000 at the end offive years when the project is terminated.Use the following rates for 5-year MACRS: 20%, 32%, 19.2%,11.52%, 11.52%, and 5.76%1) Calculate project A’s cash flows for years 0-52) Calculate NPV, IRR and PI for project A3) Calculate project B’s cash flows for year 0-54) Calculate NPV, IRR and PI for project B5) Which project should be accepted if any and why?6) What is the exact NPV profile’s crossover rate (incrementalIRR)?