Dale Corporation has two independent projects in which it can invest. The initia
ID: 2705950 • Letter: D
Question
Dale Corporation has two independent projects in which it can invest. The initial cost of the project S is $26,000, and the initial cost of the project F is $63,000. The expected income streams from these projects are found in the table below. The risks of both projects are similar to the risks of current company projects. The current risk-free rate is 0.57% and the market risk premium (return to the market minus the risk-free rate) is expected to be 6.00% per year. The company's beta is 1.55. The company will be raising all cash for these projects through debt. The company expects to pay 1.03% for any debt used in the project(s). The target capital structure for the company is 40% equity and 60% debt. The marginal tax rate is 40%.
Expected Cash Flows
by Project
Project S
Project F
Year 1
7,500
14,382
Year 2
6,614
5,526
Year 3
3,110
9,072
Year 4
5,498
17,918
Year 5
7,394
10,140
Year 6
1,528
8,320
Year 7
4,704
17,696
Year 8
5,220
14,988
a) What is the firm
Expected Cash Flows
by Project
Project S
Project F
Year 1
7,500
14,382
Year 2
6,614
5,526
Year 3
3,110
9,072
Year 4
5,498
17,918
Year 5
7,394
10,140
Year 6
1,528
8,320
Year 7
4,704
17,696
Year 8
5,220
14,988
Explanation / Answer
a. Cost of equity = risk free rate + beta * market risk premium = 0.57% + 1.55*6% = 9.87%
WACC = weight of debt * cost of debt + weight of equity * cost of equity = 60%*1.03%*(1-40%) + 40%*9.87% = 4.3188%
b. Even though these specific projects are being financed by debt only and not equity, the firm should use WACC as the appropriate rate to discount cashflows from these projects.
c. NPV for Project S = -26,000 + 7,500/(1+4.3188%)^1 + 6,614/(1+4.3188%)^2 + 3,110/(1+4.3188%)^3 + 5,498/(1+4.3188%)^4 + 7,394/(1+4.3188%)^5 + 1,528/(1+4.3188%)^6 + 4,704/(1+4.3188%)^7 + 5,220/(1+4.3188%)^8 = 9,040.716
NPV for Project F = -63,000 + 14,282/(1+4.3188%)^1 + 5,526/(1+4.3188%)^2 + 9,072/(1+4.3188%)^3 + 17,918/(1+4.3188%)^4 + 10,140/(1+4.3188%)^5 + 8,320/(1+4.3188%)^6 + 17,696/(1+4.3188%)^7 + 14,988/(1+4.3188%)^8 = 17,402.59
d. We have to calculate cumulative cashflows for each year and then calculate at what point it becomes zero.
The below is for Project S.
Cumulative cashflows -26,000 -18,500 -11,886 -8,776 -3,278 4,116 5,644 10,348 15,568 in years 0 to 8.
As we can see, the cumulative cashflow becomes zero during year 5. This would be after 3,278/7,394 = 0.4433 years. So the payback period for Project S = 4+0.4433 years = 4.4433 years
The below is for Project F.
Cumulative cashflows -48,718 -43,192 -34,120 -16,202 -6,062 2,258 19,954 34,942 in years 0 to 8.
As we can see, the cumulative cashflow becomes zero during year 6. This would be after 6,062/8,320 = 0.7286 years. So the payback period for Project F = 5+0.7286 years = 5.7286 years
e. IRR for project S can be calculated in Excel as 13.07%
IRR for project F can be calculated in Excel as 10.27%
I am unable to explain this as it is a simple straightforward formula in Excel that automatically calculates the IRR for a given set of cashflows.
f. Both projects are NPV-positive. So the company should choose both projects to maximize the value of the firm. The NPV is the amount by which the value of the firm increases when they choose that particular project.
However, if the choice is between one of the 2 projects, then the company should choose Project F as its NPV is higher than that of Project S. We should ignore the fact that IRR for Project S is higher than that of Project F.
Hope this helped ! Let me know in case of any queries.
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