The original Chegg finance question was: Sprint Co. keeps a constant debt-to-equ

Question

The original Chegg finance question was:

Sprint Co. keeps a constant debt-to-equity ratio policy equal to 1.4, its levered return on equity is 14.50% and its cost of debt is 3.75%. The company has just acquired new assets for a new project for 20,000,000 Euro. The new project will be managed separately from the rest of the company's operations and the project's assets have a risk profile comparable to the riskiness of the rest of the assets of the company. The project wiII be funded 70% with equity and 30% with debt. The debt will be kept constant through the 5 year life of the project. The assets wiII be depreciated straightline in 5 installments. The expected unlevered cash flow of the project will be 9,490,000 Euro every year. Assuming that the depreciation tax shield is as risky as the company's debt and that the corporate tax rate is 26% what is the NPV of the project?Answer: 18,460,462 Euro

The Chegg expert answer is:

new cost of equity because of change in d/e ratio is 17.85%

cost of capital=(wt of debt*cost of debt)+(wt of equity*cost of equity)

=(0.7*17.8%)+(0.3*3.75**(1-0.26))

=13.33%

NPV=-20,000,000+NPV(13.33%,cah flow form 1 to 5)

=$18,460,462

My question is: How do one find the new cost of equity because of the change in d/e ratio???

Regards

JI

Operating Cash Flow EBIT (1-tax rate Depreciation Operating cash flow 7,022,600 4,000,000 11,022,600 7,022,600 4,000,000 11,022,600 7,022,600 4,000,000 11,022,600 7,022,600 4,000,000 11,022,600 7,022,600 4,000,000 11,022,600 Total Cash Flow Initial Inv Net Working capital Operating cash flow Net salvage value 20,000,000.00 11,022,600.00 11,022,600.0011,022,600.00 11,022,600.00 11,022,600.00 Total Cash flow 20,000,000.0011,022,600.00 11,022,600.00 11,022,600.00 11,022,600.00 11,022,600.00

Explanation / Answer

THE NEW COST OF EQUITY IS NOT BECAUSE OF CHANGE IN D/E RATIO, IT HAS BEEN CALCULATED BECAUSE THE THE ACCUIRED ASSET HAS A MORE RISK POTENTIAL THAN THE OTHER ASSET.

SO IT IS OBIVIOUS THAT THE BETA OF THE PROJECT WILL BE MORE, SO A HIGHER COST OF EQUITY BEEN USED.

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