A proposed project lasts 3 years and has an initial investment of $500,000. The
ID: 2650507 • Letter: A
Question
A proposed project lasts 3 years and has an initial investment of $500,000. The after tax cash flows are estimated at $120,000 for year 1, $240,000 for year 2, and $240,000 for year 3. The firm has a target debt/equity ratio of 0.6. The firm’s cost of equity is 15% and its cost of debt is 8%. The tax rate is 35%. What is the NPV of this project? (hint: remember that the D/E is saying that debt is 60% of equity. In other words, you need to find D/A and E/A for the appropriate weights using the formulas:
20
D/E/(1+ D/E) =% or weight of debt and 1/(1+D/E) = % or weight of equity.)
Explanation / Answer
Debt Equity Ratio =.6 Debt/Equity = .6 Debt = .6 Equity Debt + Equity =1 .6 Equity + Equity = 1 1.6 Equity = 1 Equity = 1/1.6 = .625 Debt = 1 - .625 = .375 Statement showing computationof WACC Particulars Cost of Capital Weight Weighted Cost of capital Equity 15.00% 0.6250 9.38% Debt 5.20% 0.3750 1.95% 1.0000 11.33% WACC = 11.33% Kd =8%(1-.35) = 8%*.65 Statement showing calculation of Present Value Particulars Time PVF Amount PV(Amount *PVF) Cash Outflows - 1.000 (500,000.00) (500,000.00) PV of Cash outflows (500,000.00) Cash Inflows 1.000 0.8982 120,000.000 107,787.66 Cash Inflows 2.000 0.8068 240,000.000 193,636.32 Cash Inflows 3.000 0.7247 240,000.000 173,930.05 PV of Cash Inflows 475,354.03 NPV (24,645.97) Time PVF@12% Working Notes 1.00 0.8982 1/1.1133 2.00 0.8068 .8982/1.1133 3.00 0.7247 .8068/1.1133
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