Fatimah Power Company (FPC) is the primary subsidiary of Fool-Nation Power Group, representing 90% of their operating revenues. FPC is a utility company that supplies electric service in most of the major cities of Pakistan. Their service area contains 770,605 square miles which translates into approximately 14.4 million customers. Of these 14.4 million customers, as a percentage of operating income, roughly 30% comes from residential customers, 65% from commercial, 3% from industrial, and the remaining 2% from other sources. The company on annual basis paying a tax of 45% on its corporate earnings.

The financial statements of FPC show that it is financially very strong company and it has enough liquid assets to meets it’s working capital requirement. However, it floated new preferred stocks in the primary market last year at a price of Rs. 100 per share and has promised to pay dividend of Rs. 3 per share to its preferred stockholders and incurred floatation costs of Rs. 1.5 per share. The company’s capital structure after floatation of preferred stock in the open market has changed and now its capital structure includes 40% debts and 15% preferred stocks. The company’s pre-tax interest rate on debt is 9% and has paid a dividend of Rs. 2 per share to its common stockholders last year.

Pakistan’s government has recently taken drastic steps to boost investment for industrial & economic growth in the country and reduced the discount rate to a lowest level in the history of Pakistan. Now the treasury bills yield has decreased to 6% which has increased the stock market expected return to 13%. FPC trades its shares in the primary and secondary markets to accumulate equity capital from general public with a beta of 1.35.

Ali, a senior contracts agent in the nuclear division at FPC's China-Gawdar Plant in Gawdar city, is debating on whether to renew or replace the commercial nuclear reactor's reacti-meter. A reacti-meter is a vital component of the nuclear power generating process. The core of a nuclear reactor must be maintained at a certain temperature and must possess a particular chemical composition. Any deviation from this sensitive optimal mix will result in the sub-optimization of the plant and a corresponding waste of energy. The reactimeter is a computer with accompanying software that is used to monitor the requisite characteristics of the Reactor Coolant System (RCS) and make minor adjustments as needed.

In order to determine whether the reacti-meter should be renewed or replaced, Ali had to gather some financial information related to two options:

Replacement Option:

Following information is related with replacement option:

1. The new system will have a five-year life and will be depreciated by straight line.
2. Implementing the new machine would result in an increase in net working capital of Rs. 200,000.
3. If FPC decides to replace the old system with a new reacti-meter, the resulting incremental revenues will be Rs. 400,000 and the net decrease in cost will be Rs. 35,000 for the next five years.
4. At the end of the five-year period, the replaced (new) machine can be sold for Rs. 150,000 before taxes.
5. The fully depreciable cost of the new system will be Rs. 1,100,000.

Renewal Option:

Following information is related with renewal option:

1. If the current computer system is upgraded and new software is purchased, the cost will be Rs. 1,000,000 with zero salvage value.
2. An additional Rs. 70,000 will be required to have the system installed and calibrated for accuracy.
3. The renewed computer system will have a useful life of just five years and will be depreciated using straight line method.
4. At the end of the five-year period, the renewed machine can be sold for Rs. 70,000 before taxes.
5. The renewed machine would also result in an increase in net working capital of Rs. 150,000.
6. Incremental revenues resulting from an increase in operational efficiency for each year will be

Year	Rupees
1	700,000
2	525,000
3	337,000
4	255,000
5	149,000

7. Net decrease in cost will be same as replacement option.

Required:

1. What is the initial investment associated with both options?
2. Calculate the net after-tax operating cash inflows associated with both options.
3. Calculate terminal cash inflows associated with both options.
4. Calculate the cost of debt, preferred stock and common stock. Assume FPC does not have to issue any additional shares of common stock. 5. Calculate the company’s weighted average cost of capital (WACC).

6. Analyze both options using NPV and PI analyses.
7. Suggest which alternative should Ali choose and why?
8. Explain briefly why financing costs are ignored (not included) at the time of cash flow calculation for capital budgeting project?
9. Briefly explain what the difference between accounting income and cash base income.

Answer rating: 100% (QA)

What is the initial investment associated with both options ANSWER Replacement option The initial investment associated with the replacement option is Rs 1100000 This includes the cost of the new syst... View the full answer