Question

Dyrdek Enterprises has equity with a market value of $12.6 million and the market value of debt is $4.45 million. The company is evaluating a new project that has more risk than the firm. As a result, the company will apply a risk adjustment factor of 1.9 percent. The new project will cost $2.56 million today and provide annual cash flows of $666,000 for the next 6 years. The company's cost of equity is 11.79 percent and the pretax cost of debt is 5.06 percent. The tax rate is 40 percent. What is the project's NPV?

$183,363

$194,561

$556,060

$224,950

$383,149

Answer 1

Step-1, Calculation of the Discount Rate to be used to discount the annual cash flows

After-tax Cost of Debt = Pre-tax Cost of Debt x (1 – Tax Rate)

= 5.06% x (1 – 0.40)

= 5.06% x 0.60

= 3.04%

Cost of Equity = 11.79%

Market Value of Debt = $44,50,000

Market Value of Equity = $1,26,00,000

Total Market Value = $1,70,50,000

Weight of Debt = 0.2610 [$44,50,000 / $1,70,50,000]

Weight of Equity = 0.7390 [$1,26,00,000 / $1,70,50,000]

Weighted Average Cost of Capital (WACC) = (After-tax cost of Debt x Weight of Debt) + (Cost of Equity x Weight of Equity)

= (3.04% x 0.2610) + (11.79% x 0.7390)

= 0.7924% + 8.7128%

= 9.5052%

Discount Rate = Weighted Average Cost of Capital (WACC) + Risk adjustment factor

= 9.5052% + 1.90%

= 11.4052%

Step-2, Net Present Value (NPV) of the Project

Net Present Value (NPV) of the Project

Year	Annual Cash Flow ($)	Present Value factor at 11.4052%	Present Value of Cash Flow ($)
1	6,66,000	0.897624	5,97,818
2	6,66,000	0.805729	5,36,615
3	6,66,000	0.723242	4,81,678
4	6,66,000	0.649199	4,32,366
5	6,66,000	0.582737	3,88,103
6	6,66,000	0.523079	3,48,370
TOTAL			27,84,950

Net Present Value (NPV) = Present Value of annual cash inflows – Initial Investment

= $27,84,950 - $25,60,000

= $224,950

“Therefore, the Net Present Value (NPV) of the Project would be $224,950”

NOTE

The Formula for calculating the Present Value Factor is [1/(1 + r)ⁿ], Where “r” is the Discount/Interest Rate and “n” is the number of years.