Suppose Klausenheimer, Inc. is considering a new project. The project alone will

Question

Suppose Klausenheimer, Inc. is considering a new project. The project alone will cost $50,000,000 and is expected to generate after-tax cash flows of $5,000,000, $6,000,000 and 7,000,000 during the first three years. In year 4 and beyond, the after-tax cash flows are expected to grow by 3% forever. The firm has a target debt/equity ratio of .6. New equity has a flotation cost of 7% and a required return of 15%, while new debt has a flotation cost of 3% and a required return of 6%. Furthermore, you estimate that the new project is somewhat riskier that the average risk of Klausenheimer’s existing assets. To account for the additional risk, the appropriate discount rate used for the project should be 2% above Klausenheimer’s current WACC. Assuming Klausenheimer has a corporate tax rate of 35%, what is the NPV of the project?

Explanation / Answer

Suppose Klausenheimer, Inc. is considering a new project. The project alone will cost $50,000,000 and is expected to generate after-tax cash flows of $5,000,000, $6,000,000 and 7,000,000 during the first three years. In year 4 and beyond, the after-tax cash flows are expected to grow by 3% forever. The firm has a target debt/equity ratio of .6. New equity has a flotation cost of 7% and a required return of 15%, while new debt has a flotation cost of 3% and a required return of 6%. Furthermore, you estimate that the new project is somewhat riskier that the average risk of Klausenheimer’s existing assets. To account for the additional risk, the appropriate discount rate used for the project should be 2% above Klausenheimer’s current WACC. Assuming Klausenheimer has a corporate tax rate of 35%, what is the NPV of the project?

Current WACC = Weight of Equity*Cost of Equity + Weight of Debt*Cost of after tax debt

Current WACC = 1/(1+0.6) * 15% +  0.6/(1+0.6) * 6%*(1-35%)

Current WACC = 10.8375%

Appropriate discount rate = Current WACC + 2%

Appropriate discount rate = 10.8375 + 2

Appropriate discount rate = 12.8375%

NPV = -50000000 + 5000000/1.128375+ 6000000/1.128375^2 + 7000000/1.128375^3 + (7000000*1.03/(12.8375%-3%))/1.128375^3

NPV = $ 15,030,006.80

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