Question

Alex Company is planning to invest in a project. The following information is provided: Initial cash outflow = $75,000 Expected future cash flows = $20,000 every year for the next 5 years Alex’s before-tax cost of debt = 5% Tax rate = 30% Next year’s expected dividend = $1 per share Current price of the stock = $25 Expected growth rate = 4% Target capital structure = 70% equity and 30% debt Flotation costs for equity = 4%

Calculate the NPV of the project after adjusting cash flows to account for flotation costs.

Answer 1

Solution:

Calculation of NPV of the project:

a)Cost of each source of capital:

After tax cost of debt(Kd)=Before tax cost of debt(1-tax rate)

=5%(1-0.30)=3.50%

Cost of equity(Ke)=[Next year’s expected dividend/Current price of the stock(1-flotation cost)]+Growth rate

=[$1/$25(1-0.04)]+0.04

=0.0817 or 8.17%

b)WACC(Discount rate)

WACC=(Ke*Weight of equity)+(Kd*Weight of debt)

=(8.17%*0.70)+3.50%*0.30

=5.719%+1.05%=6.769%

c)NPV

NPV=Present value of after tax annual cash flows-Initial cash outflows

Present value of after tax annual cash flows=[After tax cash flows(1-tax rate)]*PVAF(6.769%,5)

=[$20,000(1-0.30)]*4.125683

=$57,760.00

NPV=$57,760.00-$75,000.00

=-$17,240.00