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

1. Earnings are not a true prediction of a firm since the accounting principal allows for accrual accounting of income i.e. expenses are matched with the related revenues and/or are reported when the expense occurs, not when the cash is paid. But cash-flow is the true measurement of firm’s income.

2. Weight of equity = 0.60

Weight of preferential shares = 0.10

Weight of debt = 0.30

Cost of equity = 15%

Cost of preferential stock = 11%

Pre-tax Cost of debt = 9.5%

Tax rate = 35%

After-tax cost of debt = (1 – 35%) * 9.5% = 6.175%

WACC = Weight of equity * Cost of equity + Weight of preferential shares + Cost of preferential stock + Weight of debt * After-tax cost of debt

                = 0.60 * 0.15 + 0.10 * 0.11 + 0.30 * .06175

                = 11.95%