Question

Dyrdek Enterprises has equity with a market value of $10.8 million and the market value of debt is $3.55 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 1.6 percent. The new project will cost $2.20 million today and provide annual cash flows of $576,000 for the next 6 years. The company's cost of equity is 11.07 percent and the pretax cost of debt is 4.88 percent. The tax rate is 40 percent. What is the project's NPV?

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)

= 4.88% x (1 – 0.40)

= 4.88% x 0.60

= 2.93%

Cost of Equity = 11.07%

Market Value of Debt = $35,50,000

Market Value of Equity = $1,08,00,000

Total Market Value = $1,43,50,000

Weight of Debt = 0.2474 [$35,50,000 / $1,43,50,000]Weight of Equity = 0.7526 [$1,08,00,000 / $1,43,50,000]

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

= (2.93% x 0.2474) + (11.07% x 0.7526)

= 0.73% + 8.33%

= 9.06%

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

= 9.06% + 1.60%

= 10.66%

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

Net Present Value (NPV) of the Project

Year	Annual Cash Flow ($)	Present Value factor at 10.66%	Present Value of Cash Flow ($)
1	5,76,000	0.90367	5,20,513
2	5,76,000	0.81662	4,70,372
3	5,76,000	0.73795	4,25,060
4	5,76,000	0.66686	3,84,114
5	5,76,000	0.60262	3,47,112
6	5,76,000	0.54457	3,13,674
TOTAL			24,60,845

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

= $24,60,845 - $22,00,000

= $2,60,845

“Therefore, the Net Present Value (NPV) of the Project would be $2,60,845”

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.