Question

A firm producing computers considers a new investment which is about opening a new plant.

The project’s lifetime is estimated as 5 years and requires 22 million $ as investment cost. Salvage value of the project is estimated as 4 million $ (which will be received in the sixth year) However the firm prefers to show salvage value only as 2 million $. The firm uses 5-year straight-line depreciation.

It is estimated that the sales will be 12 million $ next year and then sales will grow by 20% each year.

It is estimated that fixed costs will be 1.5 million next year and then will grow by 5% each year.

Variable costs are projected %10 of sales each year.

This project, in addition, requires a working capital of $ 3 million in the first year, 4 million in the second year, 4 million in the third year, 3 million in the fourth year and 1.5 million in the fifth year.

Firm plans to use a debt/equity ratio of %50 in this project.

The company can borrow $ loan with an interest cost of 14% before tax. Corporate tax rate is 20%. The shares of this company in NYSE are selling at 8 $ and the stocks have approximately market risk and have a strong correlation with NYSE index. 10- year government bond yields at %12 and market risk premium is %8.

Given this information; find the NPV and IRR of the project; is this project feasible or not?

What is the result of higher WACC ? Can a company reduce its WACC ? If yes, how? Give numerical example related with this project and explain this topic briefly regarding to the capital structure theories.

Please solve this CLEARLY

Andrew Jim Moore. UC Berkeley.

Answer 1

WACC = (debt ratio*interest cost*(1-Tax rate)) + (equity ratio*cost of equity)

D/E ratio = 0.5 so E/(D+E) (or E/V) = 1/(1+0.5) = 0.67

D/V = 1 -E/V = 1-0.67 = 0.33

Cost of equity = risk-free rate + market premium = 12% + 8% = 20% (since company has approximately the same risk as market risk)

WACC = (0.33*14%*(1-20%)) + (0.67*20%) = 17.07%

NPV & IRR calculation:

NPV = 14,563,985.70

IRR = 37.18%

The project is feasible as it has a positive NPV.

If WACC increases then NPV will decrease as the required return from the project is going up. WACC can be reduced by taking advantage of leverage. If the debt to equity ratio is increased then WACC will reduce as the debt cost is lower than equity cost and it also has the tax advantage. However, beyond a point (which depends on the sector in which the company operates and the fund raising ability of the company), the cost of debt will also increase so debt can be increased only upto that point as after that, WACC will increase, as well.

For example, in this case, if debt to equity ratio is 0.7 then WACC becomes 16.38%.