A firm is planning to invest in a new project. The initial cost of the project i

Question

A firm is planning to invest in a new project. The initial cost of the project is $1,000,000 and the project is expected to generate a risky annual year-end cash flow of $95,000, forever. The opportunity cost of capital with all-equity financing is 10%. However, the project allows the firm to borrow $400,000 of the initial cost at a cost of debt of 7%. Assuming the firm borrows the $400,000 and uses retained earnings to pay for the other $600,000, what is the value of this project to the firm? Assume a tax rate of 35% and that the debt will be fixed and perpetual. (Hint: do not be confused by the firm using retained earnings; this simply means the project is financed with $400K in debt and $600K in equity).

Explanation / Answer

WACC = Wd×Rd×(1-t)+ We×Ke

W is weights of respective portfolios

R is return on respective portfolios

= 0.40×7%×(1-35%)+0.6×10%

= 7.82%

Value of project:

= $95,000÷7.82%

= $1,214,833.76

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