Question

The director of finance has discovered an error in his WACC calculation. He did not factor in the tax rate when determining the cost of debt. UPC has a line of credit at 4% interest, and the company is taxed at 30%. Further, assume that UPC’s required rate of return on equity is 14%, and its capital structure is 40% debt and 60% equity. Additionally, the budget committee question and answer session revealed that UPC has discovered a technology that will increase its product life span by 1 year. The new technology will add $120,000 and $130,000 to projects A and B’s initial capital outlay, respectively. Further, the finance department has determined that cash flows for years 1, 2, and 3 will be unchanged. However, net cash flows for year 4 will be $300,000 and $150,000 for projects A and B, respectively. • In an Excel spreadsheet, using the UPC scenario, and the new information above, calculate the NPV, IRR, MIRR, and payback periods from projects A and B. You must input all of your data into an Excel spreadsheet and show all formulas. • Using MS Word, explain any risk factors inherent in the budgeting for the 2 projects.

Answer 1

The cash flows are as below

Year	Project A	Cumulative CF	Project B	Cumulative CF
0	-120000	-120000	-130000	-130000
1	0	-120000	0	-130000
2	0	-120000	0	-130000
3	0	-120000	0	-130000
4	300000	180000	150000	20000

The indicators are as below

	Project A		Project B
NPV	88519.90		-25740.05
IRR	25.74%		3.64%
MIRR	25.74%		3.64%
Payback	3.4		3.87

Cost of debt after tax	2.80%
Weight of debt	40%
Cost of equity	14%
Weight of equity	60%
WACC	9.5200%

Based on the above analysis, Project A must be selected since it has higher NPV.