Question 16 Phonograph Corp manufactures time series photograp D/E ratio of 1. I

Question

Question 16 Phonograph Corp manufactures time series photograp D/E ratio of 1. It's considering building a new $40 million facility. This new plant is expected to hic equipment. It is currently at its target generate after-tax cash flows of $5.5 million in perpetuity. There afe two financing options Option 1: A new issue of common stock in market with beta of 1, expected market return of 18%, and risk-free rate of 2% Option 2: A new issue of 8% 20 year bonds that will sell at par The company assigns the project a cost of WACC. Assume there is no change in the firm's capital structure after financing the project. Assuming a tax rate of 35%, what is the new plant (this problem with some tweaks for including FCF represents a comprehensive problem in this course; It includes bond valuation, CAPM, WACC, and capital budgeting)? NPV of the

Explanation / Answer

Cost of equity = 2% + (18% - 2%) × 1

= 2% + 16%

= 18%

Cost of equity is 18%.

Before tax cost of debt is 8%

Tax rate = 35%

After tax cost of debt = 8% × (1 - 35%)

= 2.60%

After tax cost of debt is 2.60%.

Now, WACC = (50% ×18%) + (50% × 5.20%)

= 9% + 2.60%

= 11.60%

WACC of company is 11.60%.

Now,

NPV = ($5.50 / 11.60%) - $40

= $47.41 - $40

= $7.41 million

NPV of project is $7.41 million.

Since, NPV of project is positive value, so project should be accepted.

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