Question

Acme Corp has a target debt/equity ratio of 0.30. It was $300 million in bonds outstanding with a yield of 6% and 50 million shares of stock outstanding with a current market price of $20 per share. The company’s beta is 1.18 and the risk-free rate of interest is 4% with a market risk premium of 6%. The firm has a tax rate of 25%. The company is looking to raise $200 million to build a second factory. The new factory will increase output substantially. The table below shows the anticipated cash flows generated from the new factory including a salvage value in year 5.

Year	Cash Flow ($mill)
0	-200
1	35
2	45
3	55
4	65
5	95

a. Calculate the NPV of the project.

b. Calculate the IRR of the project.

c. Calculate the payback of the project

Answer 1

Cost of Equity = Risk Free Rate + Beta *(Market return - Risk Free rate) = 4% +1.18*6% = 11.08%
WACC = Weight of Debt *Cost of Debt*(1-Tax Rate) + Weight of Equity * Cost of equity =0.3/(1+0.3)*6%*(1-25%)+1/(1+0.3)*11.08% = 9.5615% or 9.56%

Using Excel to calculate NPV and IRR

		A
	Year	Cash Flow ($mill)
1	0	-200
2	1	35
3	2	45
4	3	55
5	4	65
6	5	95
	NPV	16.54	Excel Formula=NPV(9.5615%,A2:A6)+A1
	IRR	12.26%	Excel Formula=IRR(A1:A6)

Year	0	1	2	3	4	5
Cash Flow ($mill)	-200	35	45	55	65	95
Cumulative Cash Flows	-200	-165	-120	-65	0	95
Payback Period	4	(Year at which cumulative cash flow=0)

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