Question

A company is about to undertake a new project. In a Modigliani and Miller world with only tax, the cash flows are given as following.

1. year	2. year	3. year	4. year	5. year
10	10	10	10	10

Risk free rate =3%, cost of debt = 6% and return on equity =15%. The CEO calculated NPV as 0. Thus, he is indifferent in terms of undertaking the project and does not know what to do. When you checked the CEO’s calculations, you realized that the company debt (D/V ratio) increased in financing this new project and the CEO use the old return on equity.   

Evaluate the decision of the CEO

Answer 1

As per MM theory with taxes, WACC can be calculated as under :

WACC = ke ×	E	+ kd × (1 - t) ×	D
V	V

Also, it states that the cost of equity can be calculated based on the following graph

Thus, it can be seen that as the level of debt increases in the company, the cost of Equity also increases. However, as Debt to value increase in the company WACC of the company decrease.

Thus, if CEO has used old D/V ratio along and old equity rate, then the WACC of the company is overvalued.

With the overvalued WACC if the NPV is Zero, then with correct WACC it will be >0.

Thus, with the correct calculation, I would advise the CEO to accept the project as it has positive NPV.