Question

A company embarks on a new project. The project will have free cash flows at the end of one year of 60 million if successful and 20 million if not successful. The probability that the project is successful is 0.4. The cost of capital if the project is unlevered is 20%. The cost of debt capital is 5%. Calculate the rate of return to investors if 10,000,000 is financed with debt.

Answer #1

If the project is succesful (0.4) - 60 million

If the project is not successful (0.6) - 20 million

Cost of capital if the project is unlevered = 20%

Cost of debt capital = 5%

Amount invested - 10,000,000 = 10 million

Calculating the present value of cash inflows in both the cases when the project is successful or not successful = (100/125 * 60 * 0.4) + (100/125 * 20 * 0.6) = 19.2 + 9.6 = 28.8

NPV = Present value of cash inflow - present value of cash outflow = 28.8 - 10 = 18.8 million

Rate of return to investor = 18.8/10 = 1.88 = 188%

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