Question

A firm is deciding to implement a new project: Investment costs are $1 million and anticipated cash flows are 300,000 for 5 years.

If the cost of capital (hurdle rate) is 12%, a) should the firm do the project? SHOW WORK

b) What determines the cost of capital? (word answer)

Answer 1

a) present value of cash flows = 300,000 x pvaf @12%,5years

.= 300,000 x 3.60478

= $1,081,432

Initial cost = $1,000,000

Net present value = 1,081,432 - 1,000,000 = $81,432

Firm should do the project because of positive net present value.

b) Cost of Capital is determined on the many factors like capital structure, exoectaexpec, risk factors, etc.

Because of tax advantages on debt issuance, it will be cheaper to issue

debt rather than new equity (this is only true for profitable firms, tax

breaks are available only to profitable firms). At some point, however, the

cost of issuing new debt will be greater than the cost of issuing new

equity. This is because adding debt increases the default risk - and thus

the interest rate that the company must pay in order to borrow money.

By utilizing too much debt in its capital structure, this increased default

risk can also drive up the costs for other sources.