Question

If Inc. were an all-equity firm, it would have a beta of 1.2. The market risk premium is 10 percent, and the return on government bond is 2 percent.

The company has a debt-equity ratio of 0.65, which, according to the CFO, is optimal. Soroc Inc. is considering a project that requires the initial investment of $28 million. The CFO of the firm has evaluated the project and determined that the project’s free cash flows will be $3.3 million per year in perpetuity. The CFO has advised two possibilities for raising the initial investment: issuing 20-year bonds or issuing common stock.

Soroc has only one bond issue outstanding that matures in 20 years, with a coupon rate of 6.29 percent and semi-annual interest payments. The bond is currently selling at the par value of $1,000. The project has the same risk as Soroc’s existing business, and it will support the same amount of debt (i.e., the firm can issue new debt without changing the risk nature of the firm). The company is in the 40 percent tax bracket.

What is the Net Present Value (NPV) of the project?

Answer 1

Cost of equity = Risk free rate + Beta (Market risk premium)

Levered beta = Unlevered beta [1 + (1-taxrate)D/E ratio]

= 1.2 [1 + (1-0.4)0.65]

= 1.2(1.39)

= 1.668

Cost of equity = 2% + 1.668(10%)

= 0.1868 or 18.68%

Cost of debt = Since the face value of bond and market vlue of bond is same, the cost of debt (YTM) is same as Coupon rate

Cost of debt = 6.29%

Post tax cost of debt = 6.29% (1-04)

= 3.774%

Weighted average cost of capital = Sum of weihted average cost of equity and debt

= 0.35 x 18.68% + 0.65 x 3.774%

= 8.9911%

Calculating NPV of new project

Present value of Cashinflow = Cash inflow/weighted average cost of capital

= 3,300,000/8.9911%

= 36,702,962

NPV = Present value of ash inflow - Cashoutflow

= 36,702,962 - 28,000,000

So NPV of project = $8,702,962