A project that costs $1 million will yield annual after-tax operating cash flow (including depreciation tax shields) of $500,000 for the next five years. The firm has a D/E ratio of 0.5 and after-tax cost of equity and debt of 20% and 10%, respectively. As this project is slightly riskier than the firm's normal operations, it is decided that an adjustment factor of +3% will be added to the discount rate for the project. What is this project's NPV?
Solution:-
D/E: 0.5
Debt=0.5*Equity
The WACC of the firm is calculated as follows:-
WACC = Cost of debt*Debt/(Debt + Equity) + Cost of equity*Equity/(Debt + Equity)
WACC = 10%*(0.5*Equity)/(0.5*Equity + Equity) + 20%*Equity/(0.5*Equity + Equity)
WACC = (5%*Equity)/(1.5*Equity) + (20%*Equity)/(1.5*Equity)
WACC = 25%/1.5
WACC = 16.67%
Discount rate = 16.67%+3% = 19.67%
NPV= -1,000,000*1 + 500,000*(1/1.1967) + 500,000*(1/1.1967)2 + 500,000*(1/1.1967)3 +500,000*(1/1.1967)4 +500,000*(1/1.1967)5
NPV = -1,000,000 + 417,815.66 + 349,139.85 + 291,752.19 + 243,797.27 + 203,724.64
NPV = $506,229.61
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