Question

Gradient Ltd is evaluating a new project that has the same risk as the overall firm. The cost is estimated at $75,000 and the expected cash flows are:

Year    Cash Flow

1          $18,000

2          $25,400

3          $35,000

4          $17,900

Currently the company has 50% debt and 50% equity. The cost of Spark’s debt is 9% and T-bills are yielding 5%. The market risk premium is 10% and Spark Ltd has a beta of 1.2. Tax rate is 30%. Should the project be accepted or rejected? Briefly explain why.

question 2

You are considering a new product. It will cost $966,000 to launch, have a 3-year life, and no salvage value. Depreciation is straight-line to zero. The required return is 20%, and the tax rate is 30%. Sales are projected at 80 units per year. Price per unit will be $40,000, variable cost per unit is $24,000 and fixed costs are $500,000 per year. Operating cash flows have been calculated for you as 642,600 per year.

1. Suppose that the sales units, price per unit, variable cost per unit, and fixed cost projections above are accurate to within 15%. What are the new variables for the best case and worst case scenarios?
2. What is the accounting break-even for this project?                                      
3. What is the degree of operating leverage?   

Answer 1

Solution:-

First we need to calculate WACC-

Cost of debt = 9%

Cost of debt after Tax = 9% (1-0.30)

Cost of debt after Tax = 6.30%

Cost of Equity as per Capital Assets pricing Model(CAPM)-

Cost of Equity = Risk Free Return + Beta * Market Risk Premium

Cost of Equity = 5% + 1.20 * 10%

Cost of Equity = 17%

WACC = Cost of debt after Tax * weight of debt + Cost of Equity * weight of Equity

WACC = 6.30% * 0.50 + 17% * 0.50

WACC = 11.65%

To Calculate Net Present value-

Net present value of the Project is Negative i.e. $1,835.90. Project is accepted when NPV of the Project is greater than or equal to zero. NPV is difference between present value of cash inflow and present value of cash outflow. Project seems to be in loss as NPV is negative. Hence, Project is Rejected.

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