Question

Dyrdek Enterprises has equity with a market value of $11.1 million and the market value of debt is $3.70 million. The company is evaluating a new project that has more risk than the firm. As a result, the company will apply a risk adjustment factor of 1.9 percent. The new project will cost $2.26 million today and provide annual cash flows of $591,000 for the next 6 years. The company's cost of equity is 11.19 percent and the pretax cost of debt is 4.91 percent. The tax rate is 40 percent. What is the project's NPV?

Answer 1

Step-1, Calculation of Weighted Average Cost of Capital to be used to discount the projects annual cash inflows

Market Value of Debt = $3,700,000

Market Value of Equity = $11,100,000

Total Market Value = $14,800,000

Weight of Debt = 0.2500 [$3,700,000 / $14,800,000]

Weight of Equity = 0.7500 [$11,100,000 / $14,800,000]

After-tax Cost of Debt = 2.95% [4.91% x (1 – 0.40)]

Cost of Equity = 11.19%

Therefore, the Weighted Average Cost of Capital (WACC) = [After-tax cost of Debt x Weight of Debt] + [Cost of Equity x Weight of Equity]

= [2.95% x 0.2500] + [11.19% x 0.7500]

= 0.7365% + 8.3925%

= 9.1290%

Therefore, the Required Rate of Return for the Project = Weighted Average Cost of Capital + Risk adjustment rate for the Project

= 9.1290% + 1.90%

= 11.0290%

Step-2, The Net Present Value of the Project

Net Present Value of the Project = Present Value of annual cash inflows – Initial Investment Cost

= $591,000(PVIFA 11.0290%, 6 Years) - $2,260,000

= [$591,000 x 4.2270059] - $2,260,000

= $2,498,161 - $2,260,000

= $238,161

“Therefore, the Net Present Value of the Project will be $238,161”

NOTE

The formula for calculating the Present Value Annuity Inflow Factor (PVIFA) is [{1 - (1 / (1 + r)ⁿ} / r], where “r” is the Discount Rate/Cost of capital and “n” is the number of years.