Question

Dyrdek Enterprises has equity with a market value of $11.4 million and the market value of debt is $3.85 million. The company is evaluating a new project that has more risk than the firm. As a result, the company will apply a risk adjustment factor of 2.2 percent. The new project will cost $2.32 million today and provide annual cash flows of $606,000 for the next 6 years. The company's cost of equity is 11.31 percent and the pretax cost of debt is 4.94 percent. The tax rate is 40 percent. What is the project's NPV?

Answer 1

WACC = (weight of debt * after tax cost of debt) + (weight of equity * cost of equity)

total market value = market value of debt +  market value of equity

total market value = $3,850,000 +  $11,400,000 = $15,250,000

weight of debt = market value of debt / total market value

weight of debt = ($3,850,000 / $15,250,000)

weight of equity = market value of equity / total market value

weight of equity = ($11,400,000 / $15,250,000)

after tax cost of debt = pre tax cost of debt * (1 - tax rate)

after tax cost of debt = 4.94% * (1 - 40%)

after tax cost of debt = 2.96%

WACC = (weight of debt * after tax cost of debt) + (weight of equity * cost of equity)

WACC = (($3,850,000 / $15,250,000) * 2.96%) + (($11,400,000 / $15,250,000) * 11.31%)

WACC = 9.203%

Discount rate to use = WACC + adjustment factor

Discount rate to use = 9.203% + 2.2% = 11.403%

NPV = sum of present values of cash flows - initial investment

present value of each cash flow = cash flow / (1 + discount rate)n

where n = number of years after which the cash flow occurs

sum of present values of cash flows = ($606,000 / (1 + 11.403%)1) + ($606,000 / (1 + 11.403%)2) + ($606,000 / (1 + 11.403%)3) + ($606,000 / (1 + 11.403%)4​​​​​​​) + ($606,000 / (1 + 11.403%)5​​​​​​​) + ($606,000 / (1 + 11.403%)6​​​​​​​)

sum of present values of cash flows = $2,534,217.30

NPV = sum of present values of cash flows - initial investment

NPV = $2,534,217.30 - $2,320,000

NPV = $214,217.30