Question

Alpha Industries is considering a project with an initial cost of $7.4 million. The project will produce cash inflows of $1.54 million a year for seven years. The firm uses the subjective approach to assign discount rates to projects. For this project, the subjective adjustment is +1.5 percent. The firm has a pretax cost of debt of 8.6 percent and a cost of equity of 13.7 percent. The debt-equity ratio is 0.0.65 and the tax rate is 35 percent. What is the net present value of the project?

Answer 1

Net Present Value: 362,855

Step-by-step explanation:

First we need to calculate the WACC to know the required return of the project.

`WACC = K_e((E)/(E+D)) + K_d(1-t)((D)/(E+D))`

Ke = 0.152 (0.137 cost of capital+ 0.015 subjective risk)

ER = 0.35 = E/(E+D)

Kd = 0.086

DR = 0.65 = D/(E+D)

t = 0.35

`WACC = .152(.35) + .086(1-0.35)(.65)`

WACC 8.95350%

Then we calcualte the net present value:

Present value of the cash flow

`C * (1-(1+r)^(-time) )/(rate) = PV\\`

C= 1,540,000

rate = 8.9535%

time 7 years

`1,540,000 * (1-(1+0.089535)^(-7) )/(0.089535) = PV\\`

PV = 7,762,855

Present value of the cash flow - Investment = NPV

7,762,855 - 7,400,000 = 362,855