Question

# Question 24 [Q24-35] Your firm’s market value balance sheet is given as follows: Market Value Balance...

Question 24

1. [Q24-35] Your firm’s market value balance sheet is given as follows:

 Market Value Balance Sheet Excess cash \$30M Debt \$230M Operating Assets \$500M Equity \$300M Asset Value \$530M Debt + Equity \$530M

Assume that the you plan to keep the firm’s debt-to-equity ratio fixed. The firm’s corporate tax rate is 50%. The firm’s cost of debt is 10% and cost of equity is 20%.

Now, suppose that you are considering a new project that will last for one year. According to your analysis, free cash flows from the project are -\$1,000 today (i.e. year 0) and \$1,322.40 one year from today (i.e. year 1). This new project can be viewed as a “carbon copy” of the entire firm’s existing business. You want to find the NPV of the project using three different DCF methods: WACC/APV/FTE.

What is the NPV of the project if the project were financed by 100% equity (i.e. unlevered)?

 A. \$20 B. \$200 C. \$160 D. \$140

Explanation :- Weight of debt = Debt / (Debt + Equity) = 230 / 530 = 0.43 (approx).

Weight of equity = Equity / (Debt + Equity) = 300 / 530 = 0.57 (approx).

Weighted average cost of capital (WACC) = Weight of debt * Cost of debt (after tax) + Weight of equity * Cost of equity

= 0.43 * 10 % * (1 - 0.50) + 0.57 * 20 %

= 0.43 * 5 % + 0.57 * 20 %

= 2.15 % + 11.4 %

= 13.55 % (Rounded off to 14 % Or 0.14).

Present value of cash inflow = Future cash inflow / (1 + WACC)

= 1322.40 / (1 + 0.14)

= 1322.40 / 1.14

= \$ 1160.

Present value of cash outflow = \$ 1000. (Given in the question).

NPV (Net present value of project) = Present value of cash inflow - Present value of cash outflow.

= 1160 - 1000

= \$ 160. (Option C).

Conclusion :- NPV of project = \$ 160. (Option C).

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