Question

Alpha Industries is considering a project with an initial cost of $8.1 million. The project will produce cash inflows of $1.46 million per year for 9 years. The project has the same risk as the firm. the firm has a pretax cost of debt of 5.64% and a cost of equity of 11.29%. The debt-equity ratio is .61 and the tax rate is 39 percent.

A. Should the Firm accept the project?

B.Calculate the Firms WACC

Answer 1

Cost of debt after-tax=5.64*(1-tax rate)

=5.64*(1-0.39)

=3.4404%

Debt-equity ratio=debt/equity

Hence debt=0.61*equity

Let equity be $x

Debt=$0.61x

Total=$1.61x

WACC=Respective cost*Respective weight

=(x/1.61x*11.29)+(0.61x/1.61x*3.4404)

=8.32%(Approx)

Present value of inflows=cash inflow*Present value of discounting factor(rate%,time period)

=1.46/1.0832+1.46/1.0832^2+1.46/1.0832^3+1.46/1.0832^4+1.46/1.0832^5+1.46/1.0832^6+1.46/1.0832^7+1.46/1.0832^8+1.46/1.0832^9

=9.00 million

NPV=Present value of inflows-Present value of outflows  

=9.00-8.1

=$0.9 million(Approx)

Hence since NPV is positive;project must be accepted