Question

The Bakery is considering a new project it considers to be a little riskier than its current operations. Thus, management has decided to add an additional 1.2 percent to the company's overall cost of capital when evaluating this project. The project has an initial cash outlay of $63,000 and projected cash inflows of $19,000 in Year 1, $34,000 in Year 2, and $28,000 in Year 3. The firm uses 33 percent debt and 67 percent common stock as its capital structure. The company's cost of equity is 13.8 percent while the aftertax cost of debt for the firm is 5.7 percent. What is the projected net present value of the new project?

Answer 1

Step-1, Calculation of the Discount Rate to be used to discount the annual cash flows

Weighted Average Cost of Capital (WACC) = (After-tax cost of Debt x Weight of Debt) + (Cost of Equity x Weight of Equity)

= (5.70% x 0.33) + (13.80% x 0.67)

= 1.8810% + 9.2460%

= 11.1270%

Discount Rate to be used to discount the annual cash flows = Weighted Average Cost of capital + Additional 1.2 percent to the company's overall cost of capital

= 11.1270% + 1.20%

= 12.3270%

Step-2,Net Present Value (NPV) of the Project

Net Present Value (NPV) of the Project

Year	Annual Cash Flow ($)	Present Value factor at 12.3270%	Present Value of Cash Flow ($)
1	19,000	0.89026	16,915
2	34,000	0.79256	26,947
3	28,000	0.70558	19,756
TOTAL			63,618

Net Present Value (NPV) = Present Value of annual cash inflows – Initial Investment

= $63,618 - $63,000

= $618

“Hence, the Net Present Value (NPV) of the Project would be $618”

NOTE

The Formula for calculating the Present Value Factor is [1/(1 + r)ⁿ], Where “r” is the Discount/Interest Rate and “n” is the number of years.