Question

Capital Structure
Debt	40%
Interest rate	5%
Tax Rate	26%
Equity	60%
Risk Free rate	6%
RM	13%
Beta	1%
Working capital	10% next year's sales
No terminal cash flows
Project 1	Capital investment	1,000,000
Year	Revenues	Expenses
1	780,000	585,000
2	799,500	599,625
3	819,488	614,616
4	839,957	629,981
5	860,974	645,731
6	882,498	661,874
7	904,561	678,421
8	927,175	695,381
Instructions
a) Compute the cost of debt financing
b) Compute the cost of equity financing using the capital asset pricing model (CAPM)
c) Compute the waighted average cost of capital (WACC)
N.B. The capital investment is to be depreciatded as a 7 years asset
d) Evaluate the project by computing: 1) Net Present Value (NPV) 2) Internal rate of return 3) Payback
e) Decision is to accept or reject the projet (based on IRR and NPV)

Look also at the effects of tax

Answer 1

Please find below spreadsheet for calculations and Answers. Formula reference also provided for better understanding -

Formula reference -

Please note -

• A project accepted when Net present value of Project is Positive and Internal rate of Return is higher than required rate of return (WACC)
• According to CAPM, Cost of equity (Ke) = Rf + Beta*(Rm-Rf) . where, Rf = risk free return & Rm = Market return.
• Post-tax cost of debt Kd = kd(1-t) , where t = tax rate.
• Depreciation expenditure is non-cash expenditure thus it would be added back EAT to determine Cash Flow.
• Increase Working capital is a cash outflow thus it would reduced from Cash flow.

Hope this will help, if you need any further explanation please comment.