Suppose you are considering a project that is expected to generate Net Cash Flow

Question

Suppose you are considering a project that is expected to generate Net Cash Flows of $175,000 in each of the first 8 years, and then $250,000 in the last 12 years (20 years in total). You are considering two different capital structures for funding the project. The first option (OPTION A) has a WACC of 6.5%, while the second (OPTION B) has a WACC of 8.2%.

Which capital structure is better and by how much? Show by comparing Net Present Values (NPV).

Better Option      ________________

By how much?   ________________

Explanation / Answer

The Net Present Value(NPV) = Present value of cash inflow - Present value of cash outflow.

In this question the present value of cash outflow is not given.So, we compare both option by present value of cash inflow.

Step1: Calulation of present value of cash inflow of Option A.We have,

Present value of cash Inflow = CF1/(1+r) + CF2 /(1+r)2 + ...... ..... + CF20 / (1 +r)20

Present value of cash inflow = 175,000 / (1.065) +175,000 / (1.065)2 +175,000 / (1.065)3 +175,000 / (1.065)4 +175,000 / (1.065)5 +175,000 / (1.065)6 +175,000 / (1.065)7 +175,000 / (1.065)8 +250,000 / (1.065)9 +250,000 / (1.065)10+250,000 / (1.065)11+250,000 / (1.065)12+250,000 / (1.065)13 +250,000 / (1.065)14 + 250,000 / (1.065)15 + 250,000 / (1.065)16 + 250,000 / (1.065)17 + 250,000 / (1.065)18 + 250,000 / (1.065)19 +250,000 / (1.065)20

Present value of cash inflow = 165,094.34 + 155,749.38 + 146,933.37 + 138,616.39 + 130,770.18 + 123,368.09 + 116,384.99 + 109,797.16 + 234,741.78 +220,414.82 + 206,962.27 + 194,330.77 + 182,470.21 + 171,333.53 + 160,876.55 + 151,057.80 + 141,838.31 + 133,181.51 + 125,053.06 + 125,053.06

Present value of cash inflow = $ 3,134,027.57

Step2: Computation of present value of cash inflow of Option 2.We have,

Present value of cash inflow = 175,000 / (1.082) +175,000 / (1.082)2 +175,000 / (1.082)3 +175,000 / (1.082)4 +175,000 / (1.082)5 +175,000 / (1.082)6 +175,000 / (1.082)7 +175,000 / (1.082)8 +250,000 / (1.082)9 +250,000 / (1.082)10+250,000 / (1.082)11+250,000 / (1.082)12+250,000 / (1.082)13 +250,000 / (1.082)14 + 250,000 / (1.082)15 + 250,000 / (1.082)16 + 250,000 / (1.082)17 + 250,000 / (1.082)18 + 250,000 / (1.082)19 +250,000 / (1.082)20

Present Value of cash inflow = 161,737.52 + 149,480.15 + 138,151.71 + 127,681.80 + 118,005.36 + 109,062.26 +100,796.91 + 93,157.96 + 231,053.60 + 213,543.07 + 197,359.59 + 182,402.58 + 168,579.08 + 155,803.22 + 143,995.59 + 133,082.80 + 122,997.04 + 113,675.64 + 105,060.66 + 97,098.58

Present value of cash inflow = $ 2,862,725.12

Step 3: Computation of difference between both option.We have,

   Difference = 3,134,027.57 - 2,862,725.12 = $ 271,302.45

(a) Option A is better than Option B.It is because Present value of cash inflow in Option A is more than Present value of Option B.

(b) Option A is better than Option B by $ 271,302.45

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