Question

1- Why financial analysts use cash flows prediction instead of accounting earnings prediction in estimating the NPV of a project?

2- ABC firm has a capital structure which is based on 60% common stock, 10% preferred stock and 30% debt. The cost of common stock is 15%, the cost of preferred stock is 11% and the pre-tax cost of debt is 9.5%. The firm's tax rate is 35%. The firm is considering a project that is equally as risky as the firm's current operations. This project has initial costs of $300,000 and annual cash inflows of $80,000, $270,000, and $112,000 over the next three years, respectively. What is the projected net present value of this project?

3- What is a bank term loan?

4- Are taxes necessary for the cost of debt financing to be less than the cost of equity financing?

5- You would like to own shares that have a record date of Friday 19 March 2018. What is the last date that you can purchase the share and still receive the dividend?

Answer 1

Question :

Question 1.

In case of a project cash flow from the project is used to do NPV analysis instead of accounting earnings or net income because

• Cash flow gives the value that project is bringing to the company while accounting earnings or net profit has many other costs associated with it.  
• Cash flows are easier to forecast
• Accounting earnings are also dependent upon accounting policies

Q2.

The weight of common stock =60%, Cost of common stock = 15%

The weight of prefereed share =10%, Cost of preffered share = 11%

The weight of debt =30%, Cost of debt (pre-tax) = 9.5%, After tax cost of debt = 9.5% * (1-0.35)= 6.175%

Cost of capital = Sum of ( weight of respective capital * cost of respective capital)

= 60% * 15% + 10% * 11% + 30% * 6.175% = 11.9525%

Project cash outflow = -300,000, Cash inflows are 80,000, 270,000 and 112,000

NPV can be calculated by discounting the cashflows with cost of capital and taking the sum of initial outflow plus discount cash Inflows

NPV = -300,000 +  80,000/(1+11.9525%)^1 + 270,000/(1+11.9525%)^2 + 112,000/(1+11.9525%)^3

NPV = -300,000 +  71458.88+ 215425 + 79820.9 = 66,704.81

So net present value of the project = 66,704.81

Q3.

Bank Term loan: A term loan is a loan offered by a bank in which they ask the customer to pay a specific amount and it has a specified repayment schedule. Interest can be fixed or floating based on the requirements

Q4.

No, taxes are not necessary for the cost of debt to become cheaper than the cost of equity. Cost of equity can be cheaper than the cost of equity without considering the tax effect.

Cost of debt is cheaper because

• Debtholder receives fixed payment on the debt irrespective of the performance of the company
• In case of liquidity, they get the claim before the equity holders

Q5.

Record date: This is the cut-off date that decides who will receive the dividend. Those who are the shareholder on this date will receive the dividend

Ex-dividend date: This date is generally one day before the record date ( varies according to the stock exchange). If one purchases share on this date or after this date then he will not be eligible for the dividend.

In the question, Record date is Friday 19 March 2018, so ex-dividend date is Thursday 18 March 2018, So if you want to receive dividend then you have to purchase on 17 March 2018 or before it

Last date is  17 March 2018