firm is considering a five- the product. The will be depreciated straight-line t
ID: 2801720 • Letter: F
Question
firm is considering a five- the product. The will be depreciated straight-line to zero over the five-year project life. The esec operating cash flow (OCF) for each year over the five-year life of the project is povds below. year expansion project to take advantage of a highet demand for project requires an initial investment in fixed assets of $8.000,000, which Year Expected operating cash flow (OCFY $3,000,000 $5,000,000 $4,000,000 $4,000,000 3,000,000 Defined as net income+ depreciation expenso The firm expects to have a before-tax salvage value of $2,000,000 at the end of the project initial net working capital investment of $1,000,000. The entire net workin The company's capital structure consists of 30 percent debt and 70 percent equity. The f has a before-tax cost of debt (i.e., yield to maturity) of 7 percent per year and a levered e beta of 1.30. The annual risk-free rate and market risk premium are 5 percent and 6 pe respectively. Assume that the project has the same capital structure and the same risk investment will be recouped at the end of the project. The tax rate is 40 percent firm overall. Find the net present value (NPV) of the project.Explanation / Answer
The Net cash flows of the business are
Post tax Salvage is computed as = 2000000*(1-0.4)
OCF is already after tax and depreciation added back. Hence it has considered the tax saving on depreciation.
Post tax Cost of debt = 7%*(1-0.4) = 4.2%
Cost of equity = Risk free rate + Beta*market premium
= 5%+1.3*6% = 12.8%
WACC = 30%*4.2%+ 70%*12.8% = 10.22%
Discounting the cash flows by WACC, using NPV function of excel as = NPV(10.22%, CF years 1-5)+ CF of year 0
we get NPV =
The WACC is
Year Initial cost Working capital OCF Salvage Net Cash flow 0 -8000000 -1000000 -9000000 1 3000000 3000000 2 5000000 5000000 3 4000000 4000000 4 4000000 4000000 5 1000000 3000000 1200000 5200000Related Questions
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