Question

Speedy Computers, Inc. is considering a new project that costs $50 million. The project will generate after-tax (year-end) cash flows or $8 million for ten years. The firm has a debt- to-equity ratio of 2/3. The equity beta for Speedy is 1.75. The expected return on the market is 12 percent and the risk- free rate is 4 percent. The cost of debt is 7.5 percent. corporate tax rate is 40 percent. The project has the same risk of the overall firm. Cal culate the NPV and decide Speedy should take on the project.

Answer 1

After tax cost of debt = 7.5%*(1-40%) = 4.5%

Cost of equity = Rf+beta*(Rm-Rf)

= 4%+1.75*(12%-4%)

= 18%

WACC = cost of debt* debt/(debt plus equity)+ the cost of equity* equity/(the debt plus equity)

= 4.5%*2/5+18%*3/5

= 12.6%

NPV = Initial cost +PV of annuity

= -50+8*(1-1/(1+12.6%)^10)/12.6%

=-50+44.11

= - $5.89 million

The project should not be undertaken since NPV is negative.