Question

Mike wants to start his own business. The initial investment required is $75,000 and the project's
         beta is 1.1. The estimated annual net cash flows are given below:

Year 1: 15,000
Year 2: 25,000
Year 3: 35,000
Year 4: 40,000

Mike can invest the same amount of funds in the market and expect to earn 12%, or he can
purchase government securities and earn 6%. Assuming that Mike's after-tax cost of debt is 7%
and his target debt to equity ratio is 0.4, calculate NPV and IRR for the project.

Answer 1

First we need to calculate WACC, which we would use as discount rate for NPV.

After tax cost of debt is given 7%.

Cost of Equity by CAPM = Risk Free rate + Beta * (Expected market return - risk free rate)

Cost of Equity = 6% + 1.1 * (12% - 6%) = 12.6%

WACC = (0.4 * 7%) + (0.6 * 12.6%) = 10.36%

NPV = $12,123.78

IRR in the above equation for NPV is "r" such that NPV is zero.

You can try calculating it manually, but would advise you using financial calculator or excel for same since manual calculation would be lengthy. In excel, use IRR function with cashflows as arguments in the function (with proper signs - negative for outflow and positive for inflow).

IRR = 16.58%

(Positive NPV is a result of IRR being higher than the WACC of the project)