Question

You just finished a capital budgeting investment analysis on a ​$156 million project. The​ project's life is 10 years and it will generate equal annual​ after-tax cash operating cash flows of ​$25 million. You assumed a ​$47 million salvage​ value, but the​ project's adjusted tax basis at termination will be ​$55 million. The project would have no effect on net working capital. With a 24​% marginal tax​ rate, the resulting NPV is ​$negative 17.853 million. What cost of capital did you use for the​ analysis? ​ (Percent with​ 1decimal)

Answer 1

Initial Outlay for the Project = $156 mn

Life of the Project = 10 years

The project will generate an equal annual​ after-tax cash operating cash flows of ​$25mn for the next 10 years.

Salvage Value (adjusted for tax) of the project at the end of 10 years = $55mn

Hence Cash Inflow for 10th year = $(25 + 55)mn = $80mn

Let us represent all the Cash Flows in the Excel

All the above cash flows are on after-tax basis.

Hence, Cost of Capital / Discount Rate used to arrive at the Net Present Value should also be on after tax basis.

NPV for the Project = $ -17.85 mn

We will use the Excel "Goal Seek" function to arrive at the Discount Rate or the "Cost of Capital"

Using the Excel, Goal Seek function, we find the Cost of Capital or Discount Rate to be 15.2%, in order to arrive at the NPV of -17.85mn

(Note: NPV is arrived by adding up the Discounted Values of the Cash Flows)

PV Factors are calculated in the following manner:-

Year 1 : 1 / (1+15.2%) ^1 = 0.87

Year 2: 1 / (1+15.2%) ^2 = 0.75

Attaching the Excel Screenshot :-

  

Hence, after-tax Cost of Capital used for the analysis = 15.2%