Question

A firm has a debt-to-value ratio of 40%, a cost of equity of 14%, and an after-tax cost of debt of 5.5%. It plans to launch a new product that will produce cash flows of $398,000 next year and $211,000 in year 2. If this project is about as risky as the firm’s existing assets, what is the present value of the project?

Multiple Choice

1.$458,008
2. $481,707
3. $500,614
4. $532,349

Answer 1

$532,349

Step-by-step explanation:

We first calculate the weighted average cost of capital to discount the cash flows,

WACC

= Weight of equity * return on equity + weight of debt * after-tax return of debt

WACC = 0.6*0.14 + 0.40*0.055 = 0.106 or 10.6%

PV of 398,000 = 398,000 * (1/1+0.106) = $359855.33

PV of 211,000 = 211,000 * (1/(1+0.106)^{2}) = $172,493.3

Total NPV = $532348.61 or $532,349 rounded

Hope that helps.