Question

A company has a capital structure which is based on a debt-equity (D/E) ratio of 2/3. The after-tax cost of debt is 6.50 percent and the cost of common stock is 16.50 percent. GEC is considering a project that is equally as risky as the overall firm. The project requires an initial investment of $400,000 and will generate after-tax cash flows of $125,000 a year for five years. What is the projected net present value (NPV) of this project?

Select one:

a. $119,460

b. $4,558

c. $75,873

d. $37,872

e. $45,071

Answer 1

Net present value of the project is present value of cash inflows minus present value of cash outflows.

Present value is the today's value of future cash inflows or outflows which is calculated using the cost of capital as discounting rate.

Therefore, we will first need to calculate the cost of capital.

There are two types of capital in this examples viz., debt and equity. The cost and ratio of both the capitals are given. Therefore, we will need to calculate the weighted average cost of capital.

Weighted average cost of capital is sum of product of cost of capital and its weightage.

Weighted average cost of capital = (cost of debt*weightage of debt) + (cost of equity*weight of equity)

Weighted average cost of capital = (6.5*2/5) + (16.5*3/5)

Weighted average cost of capital = 12.5%

Now, we need to calculate the present value of cash inflows minus present value of cash outflows using 12.5% as discounting rate.

Present value = Future value * discounting factor

discounting factor = 1/(1+r)^n

where r = cost of capital and n = period

Net present value calculated as below:

Correct answer: e. $45,071