Question

Capital Structure, WACC, and Firm Investment Suppose a firm can borrow money to finance projects from a bank at a marginal, pre- tax rate of 4.0%. Suppose the firm’s stock currently has a beta of 1.2, the market risk premium is 6% and the risk-free rate is 4.0%. The firm is currently financed with 40% debt and faces a 30% marginal tax rate. The firm is considering an average-risk project with the following free cash flows: Year 0 1 2 3 4 FCF -216,000 100,000 75,000 50,000 25,000 a. Compute the firm’s WACC. b. Compute the project’s NPV and IRR. c. Should the firm invest in the project? Why or why not? Now, assume that the CFO has determined that, when financing the project, the firm will also recapitalize so that the firm would be financed with 50% debt. d. Compute the firm’s unlevered beta. e. Compute the firm’s WACC after re-capitalizing. f. Re-calculate the project’s NPV. g. Has the firm changed its view of whether to accept the project? Explain why or why not.

Answer 1

WACC= Kd*(Wd) + Ke*(We)

Kd= 4%*(1-.3)

= 2.8%

Ke= 4% + 1.2*(6%)

=11.2%

a) WACC= 2.8%*(0.4) + 11.2%*(0.6) = 7.84%

b)

Year	Cash flow
0	-216000
1	100000
2	75000
3	50000
4	25000
WACC	7.84%
NPV	-425.1
IRR	7.73%

c) We should reject the project as we are getting a negative net present value.

d) Unlevered Beta = Equity Beta / [ 1 + ((1-t)*(D/E))]

= 1.2 / [1 + (0.7*1)]

= 0.70588

e) WACC = 2.8%*(0.5) + 11.2%*(0.5) = 7%

f)

Year	Cash flow
0	-216000
1	100000
2	75000
3	50000
4	25000
WACC	7.00%
NPV	2853.1
IRR	7.73%

g) We will accept the project as WACC has decreased and NPV is positive.