Question

3. Find the following below:

A. A group of students just learned how to calculate the cost of debt, the cost of equity, and the weighted average cost of capital. In the process of capitalist budgeting, they are evaluating different projects for what purpose? In other words, how is the cost of debt and equity related to the evaluation of projects?

B. If Billy is attempting to determine what the net present value is for a project, describe in words how he would do it if Billy has a project with the following:

•Cost of after tax debt is 6%

•Weighted average cost of capital is 12%

•Cash investment is $400

•Cash flows are $500 per year for each of the next 4 years

C. What rate do we utilize when we discuss cash flow?

Answer 1

A. Cost of the debts and the cost of equity are an important factors to be considered while evaluating the process of capital budgeting, as itis very important to evaluate which source of financing would best suit to invest in a project as debt carries a low return but would require to pay periodic interest payments, whereas in equity there is no condition to pay periodic interest but they require higher returns.

B. In order to calculate the net present value of the project, Bily has to caompare cash outflow from the project which is $400, with the net cash inflows generated by the project which is calculated by multiplying cash infows per year($500) with the present value of annuity of weighted average cost of capital of 12% for 4 years(3.037) i.e $1518.50, therefore the net present value of the project is $$1118.50.

C. if the project is financed from only Equity, then we take return on equity, But if project is financed from Debt financing,then we will use return on debt. However if project is financed by both debt and equity we will prefere to use weighted average cost of capital financing.