Question

You are considering raising dollars to invest in a project that requires an investment today of $1,000; it is a one-period project with an IRR of 15%. You will raise the dollars using a 25% debt to total assets capital structure. Debt dollars will cost 5% before tax, and equity dollars will cost 15%. Your tax rate is 30%.

1. Is the project acceptable?

2. What rate of return for the equity investors if project is accepted? Show solution of the rate of return.

Answer 1

1.

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 5*(1-0.3)

= 3.5

Weight of equity = 1-D/A

Weight of equity = 1-0.25

W(E)=0.75

Weight of debt = D/A

Weight of debt = 0.25

W(D)=0.25

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=3.5*0.25+15*0.75

WACC% = 12.13

acceptable because IRR is greater than WACC

2

Cash flow year 1 = investment*(1+IRR) = 1000*(1+0.15)

= 1150

profit to equity holder = Cash flow year 1-investmeent-interest on debt portion of investment*(-tax rate)

=1150-1000-0.25*1000*0.05*(1-0.3) = 141.25

return to equity holder = (profit/equity portion of investment)*100

=((141.25/(0.75*1000))*100 = 18.83%