Charge-On Electrical Services is considering a project that will save the compan
ID: 2799039 • Letter: C
Question
Charge-On Electrical Services is considering a project that will save the company $3.5m at the end of the first year, with the cost savings growing at 3% per year indefinitely. The firm has a D/E ratio of .55. The firm’s beta is 1.2, with a risk free rate of 2% and a market risk premium of 8%. The firm’s bonds have 25 years remaining, pay a 5% semiannual coupon, and trade at 106% of par value, which is $1,000. The corporate tax rate is 40%. How much is the project worth to the company? (Can you explain step-by-step)
Explanation / Answer
First we need to calculate the WACC for the firm
Cost of equity = Rf + beta * Market risk premium = 2 + 1.2*8 = 11.6%
Cost of debt (Semi annual yield) = rate(nper,pmt,pv,fv) = rate(25*2,25,-1060,1000)= 2.2969%
Annual yield (Pre tax cost of debt) = 2.2969 *2 = 4.594%
D/E = 0.55, D = 0.55E, if E=1, D= 0.55
Weight of debt = 0.55/1.55 = 0.3548
Weight of equity = 1-0.3548 =0.6452
WACC = weight of debt * Pre tax cost of debt *(1-tax) + weight of equity * Cost of equity
WACC = 0.3548*4.594*(1-0.4) + 0.6452*11.6 = 8.4623%
The worth of the project = PV of a growing perpetuity = Annual savings/(r-g) = 3,500,000/(0.084623-0.03) = 64,075,572.56
The project worth to the company = $64,075,572.56