Question

After-tax Interest Rates Used in Discounted Cash Flow Analysis and NPV

Apply these concepts to the analysis of investment project (e.g. factory, apartment building, equipment purchase, renovation, etc.)

The Excel Corp. has $1 million in corporate debt outstanding with a after-tax cost of 5%, and a maturity of two years. The only way it can finance a $500,000 investment is to refinance with $1.5 million of debt with a similar maturity, costing 8% after-tax. The investment would pay $55,000 in year 1 and $550,000 in year 2 (the investment has an IRR of .11). Assume that the current cost of equity is 12%, and that after refinancing, the firm will be 50% leveraged. Debt costs and cash flows are on an after-tax basis. Should the investment be accepted?

Answer 1

Let us find the WACC after the refinancing

Given After Tax cost of Debt =8%

Ungeared cost of Equity =kug=12%

D/E ratio =50:50 =1

So Geared Cost of Equity =kg=kug+(1-T)*(kug-kd)*D/E

kg=12%+4%=16%

So Cost of Equity after refinancing =16%

so WACC after refinancing=50%*16%+50%*8%=12%

We need to find the NPV of The Investment using the

WACC as the discount rate.

.

Year	Cash flow	PV factor @12%=1/1.12^n	PV of Cash flow
0	$           (500,000)	1.00	$     (500,000)
1	$               55,000	0.8929	$         49,110
2	$            550,000	0.7972	$      438,460
		Total=NPV=	$       (12,431)
As the NPV of the investment is negative, the investment should not be accepted.