Question

Sisters Ltd is planning to invest in a capital project, which will generate cash inflows of $15,000 in the 1st year, $22,000 in the 2nd year, and $25,000 in the 3rd year. The project ends after year 3. The company’s current debt to equity ratio is 0.8 with the cost of debt of 8% p.a. compounded annually. Sisters Ltd stock has a beta of 1.2. The risk-free rate is 3% p.a. compounded annually and the expected market return is 12% p.a. compounded annually. The cost of equity of 10.5% p.a. compounded annually. The new debt to equity ratio is 1. What is the total present value of the project’s cash inflows? Show your work.

Answer #1

Note: New debt equity ratio has been considered in the calculation of WACC | ||||

Source of funds | Cost | Weight | Cost * Weight | |

Debt | 8.00% | 0.5 | 4.00% | |

Equity | 10.50% | 0.5 | 5.25% | |

Weighted average cost of capital (WACC) | 9.25% | |||

Since the debt equity ratio is 1, the new weight of debt = new weight of equity = 1/2 = 0.50 | ||||

Discount factor = 1/(1+Discount rate)^No. of years | ||||

Year | Cash inflow | Discount factor | Discounted cash inflow | |

A | B | A*B | ||

1 | 15000 | 0.9153 | 13,729.98 | |

2 | 22000 | 0.8378 | 18,432.31 | |

3 | 25000 | 0.7669 | 19,172.36 | |

Present value of cash inflows | 51,334.65 |

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