Question

what you would do as the finance manager. Specifically, make sure you calculate the weighted average cost of capital, net present value and your thought process on your decision. In addition, make sure to briefly describe which of these terms are in your own words.

Your firm has the following information on their balance sheet:

Total Long-Term Debt = $2,000,000 and Total Equity of $3,000,000

The interest rate on the debt is 5% while the corporation's tax rate is 34%. Use this information to find the after-tax cost of debt.

The risk-free rate of the market is 3% while the market premium is 8%. The company's beta risk is 2.4. Use this information to find the cost of equity.

Find the WACC - weight average cost of capital and use it to discount cash flows to find the net present value of the following scenarios.

You are presented with two mutually exclusive projects (you can only invest in one).

The first investment requires an initial outlay of $400,000 and will provide the following cash flows: Year 1: $200,000, Year 2: $80,000, Year 3: $800,000, Year 4: $185,000, and Year 5: $240,000

The second investment requires an initial outlay of $300,000 and will provide the following cash flows: Year 1: $190,000, Year 2: $200,000, Year 3: $420,000, Year 4: $85,000 and Year 5: $390,000

Which investment do you choose and why? Make sure to calculate the net present value for each investment when making your recommendation.

Answer 1

AFTER-TAX COST OF DEBT:

• After-tax cost of debt (K_d)= pre-tax cost of debt X (1 - tax rate) = 5 X (1 - 34%) = 5 X 0.66 = 3.3%
• It is the cost of debt after considering tax shield (tax benefit) on interest expense.
• Most tax laws allow interest as a deduction against taxable income, leading to a reduction in tax expense due to interest deduction.
• Thus, the after-tax cost of debt is lower than the pre-tax cost of debt.

COST OF EQUITY:

• Cost of Equity (K_e) = Risk-free rate of return (R_f) + β X Market premium
• K_e = 3% + 2.4 X 8% = 22.2%
• Market premium = Market rate of return - Risk free rate of retrun (in this question, given 8%)
• Cost of equity is the return an investor in equity expects to earn.

WEIGHTED AVERAGE COST OF CAPITAL

• WACC is the company's cost of capital. It is simply the cost of equity and cost of debt weighted according to the capital structure of the company.
• 
  • K_e = Cost of equity
  • K_d = Cost of debt (after tax)
  • E = Market value of equity
  • D = Market value of debt
  • V = Market value of equity and debt
• WACC = 22.2%  X (3,000,0000/5,000,000) + 3.3%  X (2,000,000/5,000,000) = 14.64%

NET PRESENT VALUE

Investment option 1:

	Cash Flow	Present Value of 1 at 14.64%	Present Value
Year 1	200,000.00	0.8723	174,460.00
Year 2	80,000.00	0.7609	60,872.00
Year 3	800,000.00	0.6637	530,960.00
Year 4	185,000.00	0.5790	107,115.00
Year 5	240,000.00	0.5050	121,200.00
Totals	1,505,000.00		994,607.00
Amount invested			(400,000.00)
Net present value			594,607.00

Investment option 2:

	Cash Flow	Present Value of 1 at 14.64%	Present Value
Year 1	190,000.00	0.8723	165,737.00
Year 2	200,000.00	0.7609	152,180.00
Year 3	420,000.00	0.6637	278,754.00
Year 4	85,000.00	0.5790	49,215.00
Year 5	390,000.00	0.5050	196,950.00
Totals	1,285,000.00		842,836.00
Amount invested			(300,000.00)
Net present value			542,836.00

It is assumed that the cash flows are after-tax cash flows.

The first investment option should be chosen since it has a higher NPV.

• Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over the life of an investment project.
• NPV is used to evaluate investment projects in capital budgeting.
• A project with a positive NPV is accepted. A positive NPV indicates that the project will result in net cash inflows in today's dollars.
• A project with a negative NPV is rejected. A negative NPV indicates that the project will result in net cash outflows in today's dollars.
• The cash flows are discounted at a required rate of return. It may be weighted average cost of capital, cost of debt, etc.