Question

Tom is analyzing a project with an initial cost of $38,000 and free cash flow (FCF) of $29,000 a year for 2 years. This project is an extension of the firm's current operations and thus is equally as risky as the current firm. The firm uses only debt and common stock to finance its operations and maintains debt-equity ratio of 0.6. The pre-tax cost of debt is 11.0 percent and the cost of equity is 13.0 percent. The tax rate is 34 percent. What is the net present value of this project

Answer 1

$11,761.10

Step-by-step explanation:

For computing the net present value first we have to determine the weighted average cost of capital which is shown below:

WACC = Cost of debt × weighted of debt × (1 - tax rate) + cost of equity × weighted of debt

= 11% × 0.6 ÷ 1.6 × (1 - 0.34) + 13% × 1 ÷ 1.6

= 2.72% + 8.13

= 10.85%

The 1.6 is come from

= 1 + 0.6

= 1.6

The debt equity is 0.6 i.e 0.6 is for debt and equity is 1

Now the net present value is

= Present value of annual year cash flows - initial investment

where,

Present value of annual year cash flows

= Annual year cash inflows × PVIFA factor for 10.85% at 2 years

= $29,000 × 1.7159

= $49,761.10

And, the initial investment is $38,000

So, the net present value is

= $49,761.10 - $38,000

= $11,761.10