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)

Answer 1

1. cost of debt financing = interest rate *(1- tax rate) = 5% *( 1- 26%) = 0.037 = 3.7%

2. cost of equity using Capital Asset Pricing Model = Risk free rate + beta * (Return on market Rm - risk free rate)

= 6% + 1 * (13% -6%) = 13%

3. Weighted average cost of capital = cost of equity * weight of equity + cost of debt financing * weight of debt = 13%* 60% + 3.7% * 40% = 9.28%

4. Depreciation = 1000000/7 = 142857.14 as The capital investment is to be depreciatded as a 7 years asset

Working capital each year = 10% of next years' revenue ( follow excel row no. 25)

Initially EBIT is calculated using Revenue - expenses - depreciation

Free cash flow = EBIT + Depreciation - change in working capital

NPV = - investment + present value of future cash flows (NPV excel formula is shown in figure)

NPV = 110347

IRR is calculated using NPV formula where NPV = 0 while discount rate needs to be identified . IRR excel excel formula is used where 10% is guess value IRR = 11.81%

PAyback period is period where investment is recovered using future cashflow . Here till 5 years 1014716 amount is recovered . however intial investment is 1000000+78000(Working capital for year 0) = 1078000.

Thus no. of days required fro 6th year = (sum of 6 years free cash flows- 1078000)/ 1078000 * 365 days = (1233134 - 1078000)/ 1078000* 365 = 52.52 days

Total payback period = 5 years 53 days

5. If NPV is positive , then project is accepted . Here NPV is positive , so accept the project.

If IRR > WACC ( Internal rate of return > weighted average cost of capital then project is accepted .Here IRR > WACC ( 11.81% > 9.28%), so accept the project.