Question

tial cost of this project is $10 million. The depreciation expense per year is $3 million. There will be no incremental increase in net working capital. Assume that this new project is of average risk for Omicron and that the firm wants to hold constant its debt to equity ratio. The corporate tax rate is 35%. Cost of debt is 6% and cost of equity is 12%.

1. Identify the most important criteria that the company must satisfy in order to use the WACC approach.

2. Use the WACC approach to evaluate the net present value of the new project.

3. Briefly describe two disadvantages of the WACC approach compared to the adjusted present value (APV) approach.

Omicron Industries' Market Value Balance Sheet ($ Millions): Assets $ Millions $ Millions Liabilities & Equity Cash 100 Debt 200 Other Assets 500 Equity 400 Omicron Industries New Project's yearly EBIT ($ Millions): Year EBIT EBIT To 140 40

The initial cost of this project is $10 million.

Answer 1

1.Most important criteria that the company must satisfy in order to use the WACC approach

it should have more than 1 component of financing in its capital structure, like common equity, preferred equity or debt finance.

Costs of different forms of financing are calculated according to their weights/proportions in the total capital structure & the sum total is the weighted average cost of capital ,WACC.

2. WACC of Omicron Industries :

we need to take the after-tax cost of debt for calculating WACC

WACC=(Wt.d*kd)+(Wt.e*ke)

ie.(200/600*6%*(1-35%))+(400/600*12%)=

9.30%

2.NPV of the new project:
Year	0	1	2	3
1.Initial investment	-10
2.EBIT		40	50	60
3.Less: Tax at 35%(2*35%)		14	17.5	21
4.EAT(2-3)		26	32.5	39
5.Add back:Depn.(Given)		3	3	3
6.Opg.cash flow(4+5)		29	35.5	42
7.Total annual cash flows(1+6)	-10	29	35.5	42
8.PV F at 9.3% (1/1.093^Yr.n)	1	0.91491	0.83707	0.76584
9.PV at 9.3%(7*8)	-10	26.532479	29.715841	32.165389
10.NPV of the project(Sum of Row 9)	78.413709
	Millions
ie. $	78413709

3.Adjusted present value approach, takes into account ,both the tax benefits of borrowing & also the possible cost of borrowings , in the evnt of bankruptcy

whereas,

WACC considers only after-tax debt cost , in its calculations.

Not all investment proposals need to be analysed with WACC rate , as it is the return for the whole firm & may not be of much interest to the investors/owners.

whereas,

APV discounts the cash flows at the cost of equity , then goes on to adjust with interest tax shields --which clearly helps the equity holders to assess the pros & cons of the project, without any further deductions/derivations.