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
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.
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