Question

Waterdeep Adventure Travel has an unlevered cost of equity of 11.2%, and a cost of debt of 6.9%. Their tax rate is 35%, and they maintain a capital structure of 39% debt and the rest equity. They are considering giving cave exploration tours to their menu of adventure vacations. Buying the needed equipment would cost $68,080, and would bring in $38,285 one year from today, and $84,455 two years from today. What is the NPV of this project, using the WACC method, if they invest today?

Answer 1

The following data is provided:

Unlevered cost of equity=>= 11.2%

Cost of Debt=> = 6.9%

Tax Rate=>= 35%

Debt Equity Ratio =>= 39%

Equipment Cost= $68,080

Cash inflow after Year 1=$38,285

Cash inflow after Year 2= $84,455

We know from the Modigilani Miller theorem that,

Where,

• is the required rate of return on equity, or cost of levered equity
• is the company cost of equity capital with no leverage (unlevered cost of equity).
• is the required rate of return on borrowings, or cost of debt.
• is the debt-to-equity ratio.
• is the tax rate.

Now, Substituting the given values we get:

= 0.112+0.39(0.112-0.069)(1-0.35)=>12.29%

Therefore,

Weighted Average Cost Of Capital(WACC)= %of equity*+%of Debt*

=0.61*12.29%+0.39*6.9%

=10.19%

WACC is considered as the discounting rate for calculating NPV.

Present Value of Cash Inflow at the end of year 1=$38,285/1.1019=$34,744.53

Present Value of Cash Inflow at the end of year 2= $84,455/(1.1019*1.1019)=$69,557.03

NPV= PV of Cash Inflow- Cash Outflow=$(34,744.53+69,557.03)-$68,080=$36,221.56(Answer)

N.B It is assumed that,

1)After tax Cost of debt is provided.

2)After Tax Cash Inflows are provided.