Question

What is a firm's weighted-average cost of capital if the stock has a beta of 2.45, Treasury bills yield 5%, and the market portfolio offers an expected return of 14%? In addition to equity, the firm finances 30% of its assets with debt that has a yield to maturity of 9%. The firm is in the 35% marginal tax bracket.

A proposed capital project will cost $20 million and generate $4 million annually in after-tax cash flows for 6 years. The cost of capital for a project of this risk level is 12.2%. What is the project's NPV? Should the project be accepted?

Answer 1

Given,
Beta	2.45
Treasury bill yield	5%
Market return	14%
Weight of debt	0.3
Yield to maturity	9%
Tax rate	35%
Therefore,
After tax cost of debt= Yield to maturity*(1-tax rate)
	9*(1-0.35)
	5.85%
Required return on equity= Risk free rate+(Market return-Risk free rate)*Beta
	5+(14-5)*2.45
	27.05%
Weight of equity= (1-0.3)= 0.7
Weighted average cost of capital= Weighted average
	(5.85*0.3)+(27.05*0.7)
	20.69%
Calculation of NPV
Year	Cashflows($)	Discounting factor @12.2%	PV of cashflows ($)
0	-20000000	1	-20000000
1	4000000	0.891265597	3565062.389
2	4000000	0.794354365	3177417.459
3	4000000	0.707980717	2831922.869
4	4000000	0.630998857	2523995.427
5	4000000	0.562387573	2249550.291
6	4000000	0.501236696	2004946.784
		NPV	-3647104.783
NPV= Present value of future cashflows discounted at the required rate of return
	($3,647,104.783)	See table
As NPV is negative, the project should not be accepted.