Question

Question 5 Suppose you have been hired as a consultant by Stevens Steel. Stevens Steel has prepared the following estimates for a long-term project it is considering. The initial investment is $35,510, and the project is expected to yield after-tax cash inflows of $5,000 per year for 10 years. The company has also supplied you with the following information: • There are 100 million shares outstanding, trading at $5 a share • The firm has debt outstanding of $300 million, in market value terms. • The B for the firm currently is 1.04, the risk-free rate is 3% and the market risk premium is 6.5%. • The firm's pre-tax cost of debt is 6%. • The tax rate is 40%. (a) Estimate the current cost of capital for Stevens Steel (4 marks) (b) Determine the net present value (NPV) for the project (2 marks) (c) Determine the internal rate of return (IRR) for the project. (2 marks) (d) Would you recommend that the firm accept or reject the project, explain? (2 marks)

Answer 1

Sources of funds	Amount (in Million)	% of total capital	Pre tax cost of capital	Post tax cost of capital	% of total capital x Post tax cost of capital
Equity	500	62.50%	9.76%	9.76%	6.10%
Debt	300	37.50%	6%	6%*(1-40%) = 3.60%	1.35%
			3.60%	WACC	7.45%
Risk free rate	3%
Market risk premium	6.50%
Beta	1.04
Cost of equity = Risk free rate + (Beta x Market risk premium)
3%+(1.04 x 6.5%) = 9.76%
Cost of capital = WACC x Total capital
800 x 7.45% = 59.6 Million

	A	B	C	D
1	Question b)
2	Period	Investment	Excel Formula	Present value
3	0	-35,510.00	-35,510.00	-35,510.00
4	1	5,000.00	=5000/(1+7.45%)^1	4,653.33
5	2	5,000.00	=5000/(1+7.45%)^2	4,330.69
6	3	5,000.00	=5000/(1+7.45%)^3	4,030.42
7	4	5,000.00	=5000/(1+7.45%)^4	3,750.98
8	5	5,000.00	=5000/(1+7.45%)^5	3,490.90
9	6	5,000.00	=5000/(1+7.45%)^6	3,248.86
10	7	5,000.00	=5000/(1+7.45%)^7	3,023.61
11	8	5,000.00	=5000/(1+7.45%)^8	2,813.96
12	9	5,000.00	=5000/(1+7.45%)^9	2,618.86
13	10	5,000.00	=5000/(1+7.45%)^10	2,437.28
14			=SUM(D3:D13)	-1,111.10
15	Question c)
16		IRR	=IRR(B3:B13)	6.76%
17	Question d)
18	I would recommend to reject this project as the NPV of project is negative and the IRR of project is smaller than cost of capital. To accept any project the NPV should be positive and IRR should be greater than the cost of capital.
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