Question

Travis & Sons has a capital structure that is based on 40 percent debt, 5 percent preferred stock, and 55 percent common stock. The pretax cost of debt is 7.5 percent, the cost of preferred is 9 percent, and the cost of common stock is 13 percent. The tax rate is 39 percent. The company is considering a project that is equally as risky as the overall firm. This project has initial costs of $325,000 and annual cash flows of $87,000, $279,000 and $116,000 over the next three years, respectively. What is the net present value of this project? (Note: you won’t be required to find the NPV for the exam, but I want you to do this homework problem to be sure you understand that the WACC is the appropriate discount rate when evaluating projects).

Answer 1

First we have to find the Weighted average cost of capital of the firm. The formula for that is

(Cost of equity * percentage of equity) + (cost of preferred stock * percentage of preferred stock) + (cost of debt * percentage of debt*(1-tax rate)).

We put the values given to us in the question in this formula to find the weighted average cost of capital of the firm.

(0.55*0.13)+(0.05*0.09)+(0.40*0.075*(1-0.39))

= 0.0943= 9.43%

The Weighted average cost of capital of the firm is 9.43%, because the company is considering a project which is equally as risky as the overall firm, we can use the weighted average cost of capital is the internal rate of return of the project, so the internal rate of return of the project (WACC) is 9.43%.

Now in order to find the present value of the project we will discount the cash flows of the project using the IRR

Cash flow 0 = -325,000+

Cash flow 1= 87,000/1.0943

Cash flow 2= 279,000/1.0943^2

Cash flow 3= 116,000/1.0943^3

NPV= 76,011

The present value of the project is 76,011 when we discount the cash flows using an IRR or 9.43% which is also the WACC of the firm

Step-by-step explanation: