Question

Consider a project of ABC Ltd with the following characteristics:

Cash inflows: $500,000 per year for the indefinite future; Cash costs: 72% of sales;
Initial investment: $475,000;
Corporate tax: 34%;

The cost of capital for a project of an all-equity firm: 20%.

1. a) Will you accept this project?

2. b) If ABC Ltd finances the project with $150,000 in debt, will you accept this project?

Answer 1

Initial investment = $475,000

Annual Cash Revenue = $500,000

Annual Cash Cost = 72% of 500,000 = $360,000

thus,

Annual Cash Inflow (net before tax) = $140,000 (500,000-360,000)

Project period = indefinite

Tax rate(t) = 34%

a)

Cost of Capital = 20%

We can make our acceptance decision on the basis of Net Present Value (NPV) of the Project.

where,

Ke = cost of capital

t = tax rate

As the NPV of this is negative thus this project should not be accepted.

b)

Cost of Debt is not provided in question thus we can not calculate the NPV of above project if project financed by $150,000 with debt remaining by equity. But, we know Debt has tax shield benefits and it will reduce the weighted average cost of capital (WACC) for the project, reduction in cost of capital will increase the Present value of Cash inflows and can make this project acceptable.

Lets calculate the maximum cost of debt (Kd) at which Project will be acceptable. Maximum acceptable cost of debt is the rate at which NPV = 0

Where,

Weight of equity = (475,000-150,000)/475,000 = 0.68

Weight of Debt = 1- weight of equity = 1-0.68 = 0.32

Thus, If Cost of Debt (Kd) is below 13.95% then this project should be accepted.

Note- It is assumed the the cost of equity remain same after debt issue.

Hope this will help, please do comment if you need any further explanation. Your feedback would be appreciated.