Question

Stackhouse Industries has a new project available that requires an initial investment of $4.5 million. The project will provide unlevered cash flows of $675,000 per year for the next 20 years. The company will finance the project with a debt-to-value ratio of .40. The company’s bonds have a YTM of 6.8 percent. The companies with operations comparable to this project have unlevered betas of 1.15, 1.08, 1.30, and 1.25. The risk-free rate is 3.8 percent, and the market risk premium is 7 percent. The company has a tax rate of 34 percent.

  

What is the NPV of this project? (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

  

NPV

$

Answer 1

Weighted average cost of capital

We need the weighted average cost of capital (WACC) of the company to discount the cash flows.

First, we compute the average industry beta -

Average beta = (1.15 + 1.08 + 1.30 + 1.25) / 4 = 1.195

Now, Cost of equity or required return on equity as per CAPM -

Cost of equity = Risk free rate + Beta x Market risk premium = 3.8% + 1.195 x 7% = 12.165%

Pre tax Cost of debt = YTM of debt = 6.8%

After tax cost of debt = 6.8% x (1 - 0.34) = 4.488%

Weight of debt = 40% or 0.40, Weight of Equity = 1 - 0.40 = 0.60

WACC = After tax cost of debt x weight of debt + Cost of equity x weight of equity = 4.488% x 0.40 + 12.165% x 0.60 = 9.0942%

NPV

We discount the unlevered cash flows @ 9.0942% -