Question

Mainland Farms has a tax rate of 32%, a pre-tax cost of debt of 5%, and a cost of equity of 8%. The firm’s debt to equity ratio is 0.70. What is the NPV of a project that has an initial investment of $40,000 and after-tax cash flows of $12,000 per year for 6 years? (Assume the risk of the project is the same as the firm’s existing operations.)

Select one:

a. $15,474

b. $20,908

c. $12,352

d. $18,812

e. $17,616

Answer 1

	Cost of Equity is 8%
	Cost of Debt (after tax) would be
	=5%(1-Tax rate)
	=5%(1-0.32)
	3.40%
	Debt to Equity Ratio
	=Debt/Equity = 0.7
	If Equity is X amount, then Debt will be 0.7*(Equity i.e. X)
	Weighted Average Cost of Capital (WACC) = (Cost of Debt (after tax)*Proportion of Debt) + (Cost of Equity*Proportion of Equity)
	Weighted Average Cost of Capital (WACC) = (3.4%*(0.7X/1.7X)) + (8%*(X/1.7X))
	6.1059%
	Year	Cash Flows	Discount Rate @ 6.1059%	Present Value
	0	-40,000	1	-40,000
	1	12,000	0.94245	11,309
	2	12,000	0.88822	10,659
	3	12,000	0.83711	10,045
	4	12,000	0.78894	9,467
	5	12,000	0.74354	8,922
	6	12,000	0.70075	8,409
	Net Present Value	18,812
	The correct answer would be Option D - $18,812