Question

• A project to replace Dr. Robert Doback’s boat requires an initial investment of $250,000 and is expected to produce operating earnings (before depreciation and tax (EBITDA)) of $60,000 per year for 5 years

• Prestige Worldwide pays corporate taxes at a rate of 22% and can depreciate the initial investment for tax purposes at 25% in each of the first four years

• Their public debt trades at 4% and they estimate their cost of equity at 14%, the debt/equity composition is 30/70

• Calculate WACC, the project NPV and IRR

Answer 1

Answer: Formula for weighted average cost of capital

WACC = Wd * Cost of debt * (1 - tax rate) + We * Cost of equity

Wd = 0.3 , We = 0.7

Cost of Debt = 4% , Cost of equity = 14% , tax rate = 22%

WACC = 0.3 * 4% *(1-0.22) + 0.7 * 14%

WACC = 10.736%

Present value formula = net cash flow / ( 1+ wacc rate ) ^ ( no of years)

Project NPV

Year	0	1	2	3	4	5
Initial Investment	-250000
EBITDA		60000	60000	60000	60000	60000
Depreciation		62500	62500	62500	62500	0
EBIT		-2500	-2500	-2500	-2500	60000
Tax		0	0	0	0	13200
Net Cash flow	-250000	60000	60000	60000	60000	46800
Present value	-250000	54183	48930	44186	39902	28106
NPV	-34693
IRR	-5%

As you can see in this for the first 4 years our net cash flow is in negative after removing depreciation so there will be no tax

In the fifth when depreciation is 0 we will have 60000 cash flow which will be taxed at 22%

As both the NPV and IRR are in negative which tells us that this project is not beneficial for us