Question

A firm is deciding on a new project. Use the following information for the project evaluation and analysis:

        - The initial costs are $900,000 for fixed assets. The fixed assets will be depreciated straight line to a zero book value over the 3-year life of the project. The fixed assets have an estimated salvage value of $60,000 at the end of the project.

        - The project also requires an additional $200,000 for net working capital. All of the net working capital will be recouped at the end of the 3 years.

        - The project is expected to generate sales of $2,000,000 (2,000 units at a sales price of $1,000/unit), incur total costs of $1,500,000 per year (comprised of variable cost of $500 per unit and fixed costs of $500,000).

        - The firm’s marginal tax rate is 40 percent.

- The company has 50,000 shares of common stock outstanding at a market price of $25 a share. The stocks have a beta of 1.5. The risk free rate is 1%, and the market risk premium is 10%.

        - There are 1,000 bonds outstanding which mature in 13 years, have a face value per bond of $1,000, and are currently quoted at $1,250 each. The bonds have a coupon rate of 10 percent.

        - The target capital structure is 50% debt and 50% equity.

A) What is the WACC for this firm, if the corporate tax rate is 40%

B) You have determined that the project is within the typical line of business of the company. What is the NPV for this project? (Hint: Use your WACC as your discount rate)

C) What is the IRR?

D) Based on your analysis what is your recommendation? Why?

Answer 1

a)
Cost of Equity = Rf + Beta x MRP
Cost of Equity = 1% + (1.5 x 10%)	16.00%
Cost of Debt
FV	$1,000.00
Coupon Payment	$100.00
PV	1250
NPer	13
YTM = Rate = Cost of Debt	7.01%
WACC = We x Re + WD x Rd x (1- tax)
WACC = 50% x 16% + 50% x 7.01% x (1-40%)	10.10%
b)
Year	Cash Flows	PV @10.10%	Present Value
0	-$1,100,000.00	1.0000	-$1,100,000.00
1	$412,000.00	0.9082	$374,197.66
2	$412,000.00	0.8249	$339,863.80
3	$648,000.00	0.7492	$485,497.00
		NPV	$99,558.47
c) IRR	14.79%
d) Project should be accepted because NPV is positive and IRR is greater than cost of Capital.
Initial Investment = -$900,000 -$200,000	-$1,100,000.00
Annual Operating Cash Flow
Sales	$2,000,000.00
Less: Total cost	-$1,500,000.00
Less: Depreciation (900,000 -60,000)/3	-$280,000.00
EBIT	$220,000.00
Less: Tax	-$88,000.00
Net Income	$132,000.00
Add: Depreciation	$280,000.00
Net Operating Cash Flow	$412,000.00
Year 3 Cash Flow = $412000 + 200000+ 60000 x (1-40%)	$648,000.00