HoKus Corporation, a boutique clothing company, has asked for your advice on whe

Question

HoKus Corporation, a boutique clothing company, has asked for your advice on whether to invest $40 million in a new line of loungewear.

The investment will yield earnings before interest and taxes of $10 million a year, and any depreciation on the project will be invested back into the project as capital maintenance expenditure. There will be no working capital investments. The project is expected to have an infinite life.

The company has a beta of 1.2, but this project is expected to have a beta of 1.5.

The firm will maintain its existing financing mix of 60% equity and 40% debt. The cost of borrowing is 10%.

The tax rate for the company, including California State taxes, is 40%. The ten-year bond rate is 2%.

Calculate the NPV of this project. Show detailed calculations. Please explain what value you set for Rf, Rm, E(Rm), etc, so I can understand this.

Explanation / Answer

For calculating the NPV, we have to calculate the WACC.

WACC = weight of equity*cost of equity+weight of debt*cost of debt

weight of equity = 0.60 weight of debt = 0.40

Cost of debt = 10%. Tax rate = 40%. after tax cost of debt = (1-0.4)*10% = 6%

Cost of equity = risk free rate+beta*(market premium)

Risk free rate = 2% (10 year bond rate). beta= 1.5

Market premium = (Beta of project - beta)/beta = (1.5-1.2)/1.2 = 25%

So, putting values in the formula,

cost of equity = 2%+1.5*25% = 2+37.5 = 39.5%

now, putting values in the WACC formula,

WACC = 0.6*39.5+0.4*6% = 23.7+2.4 = 26.1%

Calculation of NPV:

PV of outflow = $40 million

Inflows of $10 million is infinite. Their PV = amount of inflow/WACC

= 10/.261 = 38.31

Thus NPV = PV of inflows+PV of outflows

= 38.31-40 = - 1.69 million

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