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)


Related Solutions

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...
Explain the process of evaluating an existing business.
Explain the process of evaluating an existing business.
You are a project manager evaluating the following three projects               Year                Project A &
You are a project manager evaluating the following three projects               Year                Project A                       Project B                       Project C               0                     -$150,000                      -$300,000                      -$150,000               1                     $110,000                       $200,000                       $120,000               2                     $110,000                       $200,000                       $90,000 The relevant discount rate ( r ) is 12% a year Calculate the PI for each of the three projects. Calculate the NPV for each of the three projects. If the projects were independent, and according to the PI rule, which project(s) would you...
Adams, Incorporated would like to add a new line of business to its existing retail business....
Adams, Incorporated would like to add a new line of business to its existing retail business. The new line of business will be the manufacturing and distribution of animal feeds. This is a major capital project. Adams, Incorporated is aware you an in an MBA program and would like you to help analysis the viability of this major business venture based on the following information: • The production line would be set up in an empty lot the company owns....
Consider a one-year investment that has the same risk as a firm’s existing assets. The investments...
Consider a one-year investment that has the same risk as a firm’s existing assets. The investments require $1 million immediately and has an expected IRR of 8%. The firm is considering debt financing for the $1 million with a bond with a 5% coupon paid at the end of the year. The firm’s existing debt is riskless with a yield to maturity of 5%. If the firm goes ahead, it will maintain its target debt/equity ratio of 25% and Kd...
1. Anyidado Ltd. is considering a new project that complements its existing business. The machine required...
1. Anyidado Ltd. is considering a new project that complements its existing business. The machine required for the project costs GHS3.4 million. The marketing department predicts that sales related to the project will be GHS1.9 million per year for the next four years, after which the market will cease to exist. The machine will be depreciated down to zero over its four-year economic life using the straight-line method. Cost of goods sold and operating expenses related to the project are...
You are evaluating a project with a 4 year life. Sales revenue is projected to be...
You are evaluating a project with a 4 year life. Sales revenue is projected to be $320,000 in year 1, $400,000 in year 2, $424,000 in year 3, and $475,000 in year 4. Operating expenses (excluding depreciation) are $200,000 per year. The project requires an initial investment in equipment of $240,000 which will be depreciated straight-line to zero over its four-year life. However, the actual market value of the equipment at the end of year 4 is expected to be...
A firm is evaluating a project with the following cash flow: Year 0: -$28,000 Year 1:...
A firm is evaluating a project with the following cash flow: Year 0: -$28,000 Year 1: $12,000 Year 2: $15,000 Year 3: $11,000 A) If the required return is 14%, what is the NPV? B) What is the IRR? C) If the required return is 11%, using the NPV rule, should the firm accept the project? D) What if the required return is 25%, should the firm accept the project?
Carolyn Nesbitt, the CEO of Macrocorp, is considering a project to expand the existing business into...
Carolyn Nesbitt, the CEO of Macrocorp, is considering a project to expand the existing business into a new product line that involves considerable up-front investments in new equipment as well as an initial investment in net operating working capital. Her executives’ cash flow projections are fairly aggressive with $500 M in sales at the end of the first year increasing by 5% annually for the next five years. Cost of goods sold is expected to be $250M in the first...
Carolyn Nesbitt, the CEO of Macrocorp, is considering a project to expand the existing business into...
Carolyn Nesbitt, the CEO of Macrocorp, is considering a project to expand the existing business into a new product line that involves considerable up-front investments in new equipment as well as an initial investment in net operating working capital. Her executives’ cash flow projections are fairly aggressive with $500 M in sales at the end of the first year increasing by 5% annually for the next five years. Cost of goods sold is expected to be $250M in the first...
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT