Question

Assume that you are a new analyst hired to evaluate the capital budgeting projects of the company which is considering investing in two CPEC projects, “Expansion Zone North” and “Expansion Zone East”. The initial cost of each project is Rs. 10,000. Company discount all projects based on WACC. Further, all the projects are equally risky projects and the company uses only debt and common equity for financing these projects. It can borrow unlimited amounts at an interest rate of rd 10% as long as it finances at its target capital structure, which calls for 50% debt and 50% common equity. The dividend for next period is $2.0, its expected that they will grow at the constant growth rate of 8%, and the company’s common stock sells for $20. The tax rate is 50%.

The cash flows of both the projects are given in table below:

Time Expansion Zone North
Cashflows (amount in Rs.) Expansion Zone East
Cashflows (amount in Rs.)
0 - 10,000 - 10,000
1 6,500 3,500
2 3,000 3,500
3 3,000 3,500
4 1,000 3,500

Answer 1

Cost of Debt after Tax = Rd ( 1 - Tax rate )

= 10% * ( 1 - 0.5 )

= 10% * 0.5

= 5%

COst of Equity:

Particulars	Amount
D1	$             2.00
Growth rate	8%
Price	$           20.00

Ke = [ D1 / P0 ] + g
= [ 2 / 20 ] + 0.08
= 0.1 + 0.08
= 0.18
I.e18 %

Where

D1 = Expected Div after 1 Year
P0 = Price Today
Ke = Required Ret
g = Growth Rate

WACC:

WACC is weighted Average cost of sources in capital structure.

Source	Weight	Cost after Tax	Weighted Cost
Debt	0.5000	5.00%	2.50%
Equity Stock	0.5000	18.00%	9.00%
WACC			11.50%

NPV :
NPV = PV of Cash Inflows - PV of Cash Outflows
If NPV > 0 , Project can be accepted
NPV = 0 , Indifference point. Project can be accepted/ Rejected.
NPV < 0 , Project will be rejected.

Project North Zone:

Year	CF	PVF @11.5 %	Disc CF
0	$      -10,000.00	1.0000	$       -10,000.00
1	$          6,500.00	0.8969	$           5,829.60
2	$          3,000.00	0.8044	$           2,413.08
3	$          3,000.00	0.7214	$           2,164.20
4	$          1,000.00	0.6470	$              646.99
NPV			$          1,053.87

Project East Zone:

Year	CF	PVF @11.5 %	Disc CF
0	$      -10,000.00	1.0000	$       -10,000.00
1	$          3,500.00	0.8969	$           3,139.01
2	$          3,500.00	0.8044	$           2,815.26
3	$          3,500.00	0.7214	$           2,524.90
4	$          3,500.00	0.6470	$           2,264.48
NPV			$              743.65

Project North Zone is selected as it has higher NPV.