Question

ABC Corporation has developed an improved version of its most popular product. To get this improvement to the market will cost £48 million, but the project will return an additional £13.5 million for 5 years in net cash flows. The firm's debt-equity ratio is .25, the cost of equity is 13 per cent, the pretax cost of debt is 9 per cent, and the tax rate is 21 per cent. All interest is tax deductible. What is the net present value of this proposed project? Provide a definition for net present value.

Answer 1

Calculation of the Discount rate used for NPV:-

discount rate is WACC.

WACC = cost of debt before tax * weight of debt * (1 - tax rate ) + cost of equity * weight of equity

= 9% * 0.25 * (1 - 0.21) + 13% * 0.75

= 1.7775% + 9.75%

WACC = 11.5275%

Here net cash flows are given in question.

NPV = present value of cash inflows - initial investment.

Here cash inflows are same,so we use present value of annuity concept.

Present value of cash inflows = 13.5 million * PVAF ( 11.5275% ,5 years)

= $ 13.5 million * 3.6474

Present value of cash inflows = $ 49.2399 million

NPV = $ 49.2399 Million - 48 million =$ 1.2399 million