Question

25. A company is considering a new project it considers to be riskier than its current operations. Thus, management has decided to add an additional 3% to the company’s overall cost of capital when evaluating this project. The project has an initial cash outlay of $50,000 and projected net cash inflows of $20,000 in year one, $25,000 in year two, and $30,000 in year three. The firm uses 50% debt and 50% common equity in its capital structure. The company’s after-tax cost of debt is 4% while the company’s cost of equity is 12%. What is the projected net present value of the new project?

Answer 1

WACC is calculated by using the formula below:

WACC= wd*kd(1-t)+we*ke

where:

Wd=percentage of debt in the capital structure

We=percentage of equity in the capital structure

Kd=cost of debt

Ke=cost of equity

t= tax rate

WACC= 0.50*4% + 0.50*12%

= 2% + 6%

= 8%.

WACC to use when evaluating the project= 8% + 3%= 11%

Net present value can be solved using a financial calculator. The steps to solve on the financial calculator:

• Press the CF button.
• CF0= -$50,000. Indicate the initial cash flow by a negative sign since it is a cash outflow.  
• Cash flow for each year should be entered.
• Press Enter and down arrow after inputting each cash flow.
• After entering the last cash flow cash flow, press the NPV button and enter the weighted average cost of capital of 11%.
• Press enter after that. Press the down arrow and CPT buttons to get the net present value.  

Net present value at 11% weighted average cost of capital is $10,244.32.