Hatteras wants to submit a report that answers the following questions — Southwestern Electric Company36 John financial analyst for Company responsible preliminary analysis

Southwestern Electric Company36 John Hatteras, the financial analyst for Southwestern Electric Company, is responsible for preliminary analysis of the company’s investment projects. He is currently trying to evaluate two large projects that management has decided to consider as a 36. This problem is really a short case. It has a definite answer but requires knowledge of cash flows, discounting, the CAPM, and risky cost of capital. single joint project, because it is felt that the geographical diversification the joint project provides would be advantageous.

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

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?

SOLUTION

Because Southwestern will finance the new project with 50 percent debt, the before-tax cost of debt is

Since corporate debt is assumed to be risk-free, the market equilibrium risk-free rate is also 6 percent. It is important to recognize that the market equilibrium rate should not be adjusted by the tax rate. Knowledge of the risk-free rate, the expected return on the market, and the market beta allows us to determine the market price of risk (the slope of the security market line).

E (Rm) – Rt = slope = 18% – 6% / 1.0 = 12%

The firm has a D / D + E ratio of 50 percent and a beta of .5.

(a) Project 1. The cash flows are operating cash flows and are, therefore, unlevered. First, we find ρ for project 1, then we solve for the appropriate discount rate assuming it has the same leverage as the firm.

βUj (the levered β) is .4375

ρ = E (Rj) = Rf + [E (Rm) – Rf]βj

= .06 + [.18 − .06] .4375

= .06 + .0525 = 11.25%

The required rate of return on equity invested in the project assuming it has the same leverage as the firm is:

ks = + ( – Rt) (1 – c) B / S

= .1125 + (.1125 – .06) (1 – .4)1

= .1125 + .0315 = 14.4%

The correct discount rate on the project is its after-tax weighted average cost of capital.

Repeat the same procedure for project 2, which has an unlevered Uj = .75.

ρ= Rf + [E (Rm) – Rf] βj

= .06 + (.18 − .06) .75

= .06 + .09 = 15%

Now find the required rate of return on equity if the project has the same leverage as the firm as a whole.