Question

In: Finance

You are evaluating a 1-year project that is in line with the firm’s existing business. Specifically,...

You are evaluating a 1-year project that is in line with the firm’s existing business. Specifically, this new project requires an investment of $1,200 in free cash flow today, but will generate $1,600 one year from today. The project will be partially financed with a 1-year maturity debt whose face value is $200 and interest rate is 10%.

Suppose that you estimated the cost of equity as 20%, based on the firm’s stock data. However, you were not able to estimate the cost of debt because your firm’s total debt consists of long-term debt, short-term debt, investment grade debt, and debt with different levels of collateral. Assume that the corporate tax rate is 30%.

a) Under the FTE approach, the NPV of the project is obtained by discounting future FCFE using the _______.

A.

Cost of assets
B.

Cost of unlevered equity
C.

Weighted average cost of capital
D.

Cost of levered equity

b) What is the NPV of this project?

A.

$21
B.

$80
C.

$155
D.

$14

Solutions

Expert Solution

a). Answer :- Option C). Weighted average cost of capital (WACC).

Explanation :- Future cash flows of project will be discounted by weighted average cost of capital (WACC) while calculating the net present value (NPV) of project.

Value of equity = Total investment in project - Amount of debt invested in project.

= 1200 - 200

= $1000.

Weight of debt = Debt / (Debt + Equity)

= 200 / (200 + 1000)

= 200 / 1200

= 0.17 (approx).

Weight of equity = Equity / (Debt + Equity)

= 1000 / (200 + 1000)

= 1000 / 1200

= 0.83 (approx).

Cost of debt (after-tax) = Pre-tax cost of debt * (1 - Tax rate).

= 10 % * (1 - 0.30)

= 10 % * 0.70

= 7 %

WACC is calculated as follows:-

WACC = Weight of debt * Cost of debt (after-tax) + Weight of equity * Cost of equity.

= 0.17 * 7 % + 0.83 * 20 %

= 1.19 % + 16.6 %

= 17.79 % Or 0.1779

b). Answer :- Option C). $155

Explanation :- NPV (Net present value) of project = Present value of cash inflows - Present value of cash outflow.

= Future cash inflow in year 1 / (1 + WACC)Time period in years - Initial project investment.

= 1600 / (1 + 0.1779)1 - 1200

= 1600 / (1.1779) - 1200

= 1358 (approx) - 1200

= $ 158 (Most nearest to $ 155 mentioned in option c to the given question)

jeff jeffy answered 1 year ago
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