Question

A project that costs $1 million will yield annual after-tax operating cash flow (including depreciation tax shields) of $500,000 for the next five years. The firm has a D/E ratio of 0.5 and after-tax cost of equity and debt of 20% and 10%, respectively. As this project is slightly riskier than the firm's normal operations, it is decided that an adjustment factor of +3% will be added to the discount rate for the project. What is this project's NPV?

Answer 1

Solution:-

D/E: 0.5

Debt=0.5*Equity

The WACC of the firm is calculated as follows:-

WACC = Cost of debt*Debt/(Debt + Equity) + Cost of equity*Equity/(Debt + Equity)

WACC = 10%*(0.5*Equity)/(0.5*Equity + Equity) + 20%*Equity/(0.5*Equity + Equity)

WACC = (5%*Equity)/(1.5*Equity) + (20%*Equity)/(1.5*Equity)

WACC = 25%/1.5

WACC = 16.67%

Discount rate = 16.67%+3% = 19.67%

NPV= -1,000,000*1 + 500,000*(1/1.1967) + 500,000*(1/1.1967)² + 500,000*(1/1.1967)³ +500,000*(1/1.1967)⁴ +500,000*(1/1.1967)⁵

NPV = -1,000,000 + 417,815.66 + 349,139.85 + 291,752.19 + 243,797.27 + 203,724.64

NPV = $506,229.61