Southwestern Electric Company36 John Hatteras, the financial analyst for Southwestern Electric Company, is responsible for preliminary analysis
Question:
Southwestern Electric was founded in the early 1930s and has operated profitably ever since. Growing at about the same rate as the population in its service areas, the company has usually been able to forecast its revenues with a great deal of accuracy. The stable pattern in revenues and a favorable regulatory environment have caused most investors to view Southwestern as an investment of very low risk.
Hatteras is concerned because one of the two projects uses a new technology that will be very profitable, assuming that demand is high in a booming economy, but will do poorly in a recessionary economy. However, the expected cash flows of the two projects, supplied by the engineering department, are identical. The expected after-tax cash flows on operating income for the joint project are given in Table Q 15.21. Both projects are exactly the same size, so the cash flow for one is simply half the joint cash flow.
Table Q15.21
.png)
In order to better evaluate the project, Hatteras applies his knowledge of modem finance theory. He estimates that the beta of the riskier project is .75, whereas the beta for the less risky project is .4375. These betas, however, are based on the covariance between the return on after-tax operating income and the market. Hatteras vaguely recalls that any discount rate he decides to apply to the project should consider financial risk as well as operating (or business) risk. The beta for the equity of Southwestern is .5. The company has a ratio of debt to total assets of 50% and a marginal tax rate of 40%. Because the bonds of Southwestern are rated AAA, Hatteras decides to assume that they are risk free. Finally, after consulting his investment banker, Hatteras believes that 18% is a reasonable estimate of the expected return on the market.
The joint project, if undertaken, will represent 10% of the corporation's assets. Southwestern intends to finance the joint project with 50% debt and 50% equity.
Hatteras wants to submit a report that answers the following questions:
(a) What is the appropriate required rate of return for the new project?
(b) What are the cost of equity capital and the weighted average cost of capital for Southwestern Electric before it takes the project?
(c) Should the joint project be accepted?
(d) What would the outcome be if the projects are considered separately?
(e) If the joint project is accepted, what will the firm's new risk level be?
Cost of capital refers to the opportunity cost of making a specific investment . Cost of capital (COC) is the rate of return that a firm must earn on its project investments to maintain its market value and attract funds. COC is the required rate of... Cost Of Equity
The cost of equity is the return a company requires to decide if an investment meets capital return requirements. Firms often use it as a capital budgeting threshold for the required rate of return. A firm's cost of equity represents the... Discount Rate
Depending upon the context, the discount rate has two different definitions and usages. First, the discount rate refers to the interest rate charged to the commercial banks and other financial institutions for the loans they take from the Federal... Expected Return
The expected return is the profit or loss an investor anticipates on an investment that has known or anticipated rates of return (RoR). It is calculated by multiplying potential outcomes by the chances of them occurring and then totaling these...
Step by Step Answer:
Because Southwestern will finance the new project with 50 percent debt the beforetax cost of debt is Since corporate debt is assumed to be riskfree the market equilibrium riskfree rate is also 6 perce...View the full answer
Financial Theory and Corporate Policy
ISBN: 978-0321127211
4th edition
Authors: Thomas E. Copeland, J. Fred Weston, Kuldeep Shastri
