In: Finance
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 |
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)