Question

9. The Excel Corp. has $1 million in corporate debt outstanding with a after-tax cost of 5%, and a maturity of two years. The only way it can finance a $500,000 investment is to refinance with $1.5 million of debt with a similar maturity, costing 8% after-tax. The investment would pay $55,000 in year 1 and $550,000 in year 2 (the investment has an IRR of .11). Assume that the current cost of equity is 12%, and that after refinancing, the firm will be 50% leveraged. Debt costs and cash flows are on an after-tax basis. Should the investment be accepted?

Answer 1

The company will be 50% leveraged after the investment which means it will have 50% debt and 50% equity.

Cost of capital = Cost of equity x Weight of equity + After tax cost of debt x Weight of debt

or, Cost of capital = 12% x 0.50 + 8% x 0.50 = 10%

We compute the NPV of the investment using this rate. Normally, we would simply ignore the existing debt but this investment actually increases its cost from 5% to 8% which we need to consider.

Particulars	Year 1	Year 2
Cash flow	$55,000	$550,000
Less: Increased interest on existing debt [ $1,000,000 x (8% - 5%) ]	$30,000	$30,000
Net cash flow	$25,000	$520,000

NPV = (-)$500,000 + [ $25,000 / (1 + 0.10)¹ ] + [ $520,000 / (1 + 0.10)² ] = (-)$47,520.661158 or (-)$47,520.66

Since NPV is negative, we should not accept the investment.