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	850,000	680,000
2	871,250	697,000
3	893,031	714,425
4	915,357	732,286
5	938,241	750,593
6	961,697	769,358
7	985,739	788,592
8	1,010,383	808,306
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)

Answer 1

a)Cost of debt financing = Kd(1-t)=5%(1-26%)=0.037 (or) 3.7%

b Given, Beta=1, Risk Free rate = 6%, RM= 13%

Cost of Equity= Rf +Beta(Rm-Rf) = 6% +1(13%-6%)= 13%

c) WACC = Wd*Kd(1-t) +We*Kce = 40%*3.7% + 60%*13% = 9.28%

d) Net Cash Flow = Revenue- Expenses

Year	Net Cash Flow	Cumulative NCF
0	-1,000,000	-1,000,000
1	170,000	-830,000
2	201,250	-628,750
3	178,606	-450,144
4	183,071	-267,073
5	187,648	-79,425
6	192,339	112,914
7	197,147	310,061
8	202,077	512,138

Payback Period = Full years until recovery + ( un recovered cost at the beginning of last year/Cash flow during last year)= 5 + (79,425/192,339)= 5.4129 years

NPV= CF0+ (CF1/(1+k))+ (CF2/(1+k)^2) +....+(CFn/(1+k)^n)

K is cost of capital=9.28%

IRR is the return where NPV will be Zero.

Using Excel, NPV and IRR are calculated and attached below

Excel function for NPV is NPV(Rate, Cash flow Values)

Excel function for IRR is IRR (Cash flow Values)

e) IRR > Cost of Capital and NPV is positive, So Decision is to accept the project