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?
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.
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