Question

The company currently has a target debt–equity ratio of .45, but the industry target debt–equity ratio is .40. The industry average beta is 1.20. The market risk premium is 8 percent, and the risk-free rate is 6 percent. Assume all companies in this industry can issue debt at the risk-free rate. The corporate tax rate is 40 percent. The project requires an initial outlay of $680,000 and is expected to result in a $100,000 cash inflow at the end of the first year. The project will be financed at the company’s target debt–equity ratio. Annual cash flows from the project will grow at a constant rate of 6 percent until the end of the fifth year and remain constant forever thereafter.

Calculate the NPV of the project. I am having a hard time figuring out how to get the right answer the last answer I got was 329743.11

How do you find the right answer?

Answer 1

Net Present Value is the net inflow from the project that will acrue over forsseable future. But to make an aware situation, the same has to be brought to the present value, to arrive at the correct profitabilty from the poject. For discounting purposes, we require Weighted Average Cost of Capital (WACC).

For Calculation of WACC we require weights of both equity and debt,

WACC = Weighted Expected rate of return + Weighted Debt Interest rate (Post tax)

Expected rate of return shall be calculated using CAPM Model such that,

Ex = Riske Free rate + Beta Average (Risk Premium)

= 6 + 1.2 (8) = 15.6%

Debt Interest Rate = Risk Free rate ( 1- Tax Rate)

= 6 (1-0.4) = 3.6%

Particulars	Rate	Weightage	Weighted Returns
Equity	15.6	0.6	9.36
Debt	3.6	0.4	1.44
WACC			10.8 %

Calculation of NPV:

NPV = PV of Inflow for 1st 5 Years + Cash Flows for the future - Initial Investment

PV of Inflow for 1st 5 Years

Year	Cash Flow	Net Inflow after tax	DCF @ 10.8%	PV Net Inflow
1	1,00,000	60,000.00	0.90	54,151.62
2	1,06,000	63,600.00	0.81	51,805.71
3	1,12,360	67,416.00	0.74	49,561.42
4	1,19,101.60	71,460.96	0.66	47,414.35
5	1,26,247.70	75,748.62	0.60	45,360.30
Total				$ 2,48,293.40

Cash Flows for the future = [(Cash Inflow for the 6th year) / WACC] / (1 + WACC)5

= [( 75,748.62) / 0.108] / (1.108)5

= $ 4,20,002.81

NPV = $ 2,48,293.40 + $ 4,20,002.81 - $ 6,80,000

= ($ 11,703.79)

As NPV is negative, project should be opt out.

Note: Interest on Debt is not taken in the NPV calculation, as the previous amout of debt is not mentioned.