Gilligan's Island Power Debacle

Gilligan's Island Project

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Gilligan's Island Project

        Gilligan’s Island has recently been presented with several options regarding how they should proceed considering a power issue. They can pay a one-time pollution tax (Carbon Offsets) of $13,000,000 immediately.  Or they could close the plant and install a power cable from the mainland to the Island.  Doing so would cost $1,000,000 at the end of this year, $3,000,000 at the end of next year and then $750,000/year forever for maintenance. The plan could be retrofitted with scrubbers to reduce the emissions to make the plant green, at a cost of $7,500,000 at the end of this year and $100,000 for 50-years for maintenance. To determine which option is the most appropriate, it is necessary to better understand their current financial position. The organization does not have any saved. The organization must identify capital via investment and/or other options. The organization currently has a 12% market risk premium on the power plant with the risk-free rate being 5% and a company tax rate of 35%.

        To continue, the debt of the organization has been determined to be 7,000 outstanding bonds, at 7.5% coupon and 20 years to maturity. The bonds pay interest semi-annually, however this is not a substantial amount of income. The organization’s common stock are 180,000 shares outstanding, selling for $50 per share with beta .90 CAPM is 11.8%. Lastly, the preferred stock numbers are 8,000 shares of 5.5% preferred stock outstanding, currently selling for $95.00 per share. Using this information, our purpose is to perform a financial analysis on the power plant using WACC to determine which option is the most appropriate given the current circumstances.

Cost Analysis

Cost of Bond

        The value of one bond is $1080. The Kd of the bond is found by:

Kd = [interest + (par value – market value)/n] [(market value + par value)/2]

This would result in the below calculation:

= [37.5+ (1080 – 1000)/40] [(1000 + 1080)/2]

= 3.798 % (1-35%)

 = 2.47%

Cost of Equity

        The CAPM is found by:

CAPM = Rf+Ba(Rm-Rf)

= 5% + 0.9%*12%

=5.108%

Cost of Stock

        The cost of the stock is found by:

Cost of stock = % preferred stock/price per share

= 5.55/$95.00

= 5.79%

Capital Analysis

[pic 1]

Table 1: Capital (stock and debt)

Common Stock

Weight of Stock = 9,000,000/17,320,000

= 51.96%

Debt

Weight of Debt = 7,560,000/ 17,320,000

= 43.65%

Preferred Stock

Preferred Stock Weight = 760,000/17,320,000

= 4.39%

WACC

        The WACC can be calculated using the following equation:

WACC = [pic 2] * Re + [pic 3] * Rd * (1 – Tc)

WACC = 51.96%*5.79% + 43.65%* 16.35% + 4.39% *5.5%

= 10.38%

Therefore, it could be concluded that the discounted rate of return is approximately 10.4%.

Option Analysis

Option #1

        If $13,000,000 must be paid immediately, then the NPV of cash flow will be positive and the project will generate returns moving forward.