Question

NEC is considering a $45M project in its power systems division. The CFO estimates that the project’s unlevered cash flows will be $3.1M per year, in perpetuity. The CFO has devised two possibilities for raising the initial capital: Issuing 10-year bonds or issuing common stock. NEC’s pretax cost of debt is 6.9%, and its cost of equity is 10.8%. The company’s target debt-to-value ratio is 80%. The project has the same risk as NEC’s existing businesses, and it will support the same amount of debt. NEC is in the 34% tax bracket.

Should NEC accept this project?

Answer 1

Attaching the calculations and the formulas used :-

A В C Particulars Cash Flow 2 Initial Outflow 45,000,000 4 Unlevered Cash Flows 5 3,100,000 6 Pre-tax cost of debt 6.9% 7 34% 8 Tax Rate Post-tax cost of debt 4.55% 9 10 Cost of Equity 10.80% 11 12 Debt Value Ratio 80.00% 13 20.00% 14 Equity to Value Ratio 15 5.80% 16 WACC 17 Present Value of the Project 18 53,418,803 19 20 NPV 8,418,803 C

A B C Particulars Cash Flow 2 Initial Outflow 45*10^6 4 Unlevered Cash Flows 3.1*10^6 5 6 Pre-tax cost of debt 7 0.069 Tax Rate 0.34 Post-tax cost of debt =C7*(1-C8) 10 Cost of Equity 11 0.108 12. Debt to Value Ratio 13 0.8 14 Equity to Value Ratio 1-C13 15 | (C9*C13)+C11*C14) 16 WACC 17 Present Value of the Project C5/C16 18 19 20 NPV C18-C3 n N

Since, the Project generates a positive NPV of $8,418,803, NEC should accept the project