Question

Company is evaluating a 10-year project requiring an initial investment of $50 million. The firm has made the following projections:

EBIT = $10 million
Interest Expense = $2 million
Tax Rate = 40%
Depreciation = $5 million/year
Debt/Equity Ratio = 20%
Cost of Equity = 15%
Total Cost of Capital = 12%

The firm does not intend to change its debt to equity ratio when making additional investments. Using FCFF, what is the expected net present value (NPV) of this project for the firm?

Select one:

A. $9.18 million

B. $12.15 million

C. $16.83 million

D. $21.34 million

Answer 1

Step 1: Calculate Free Cash Flow to the Firm

The value of free cash flow to the firm is calculated with the use of following formula:

FCFF = EBIT*(1-Tax Rate) + Depreciation

Using the values provided in the question in the above formula, we get,

FCFF = 10*(1-40%) + 5 = $11 million per year

_____

Step 2: Calculate NPV

NPV is the difference between the present value of cash inflows and cash outflows. It can be calculated with the use of following formula:

NPV = -Initial Investment + Free Cash Flow Year 1/(1+Cost of Capital)^1 + Free Cash Flow Year 2/(1+Cost of Capital)^2 + Free Cash Flow Year 3/(1+Cost of Capital)^3 + Free Cash Flow Year 4/(1+Cost of Capital)^4 + Free Cash Flow Year 5/(1+Cost of Capital)^5 + Free Cash Flow Year 6/(1+Cost of Capital)^6 + Free Cash Flow Year 7/(1+Cost of Capital)^7 + Free Cash Flow Year 8/(1+Cost of Capital)^8 + Free Cash Flow Year 9/(1+Cost of Capital)^9 + Free Cash Flow Year 10/(1+Cost of Capital)^10

Using the value of FCFF calculated in Step 1 and Cost of Capital provided in the question, we get,

NPV = -50 + 11/(1+12%)^1 + 11/(1+12%)^2 + 11/(1+12%)^3 + 11/(1+12%)^4 + 11/(1+12%)^5 + 11/(1+12%)^6 + 11/(1+12%)^7 + 11/(1+12%)^8 + 11/(1+12%)^9 + 11/(1+12%)^10 = $12.15 million (which is Option B)