Question

1. You are evaluating a 1-year project that is in line with the firm’s existing business. Specifically, this new project requires an investment of $1,200 in free cash flow today, but will generate $1,600 one year from today. The project will be partially financed with a 1-year maturity debt whose face value is $200 and interest rate is 10%. Suppose that you estimated the cost of equity as 20%, based on the firm’s stock data. However, you were not able to estimate the cost of debt because your firm’s total debt consists of long-term debt, short-term debt, investment grade debt, and debt with different levels of collateral. Assume that the corporate tax rate is 30%. What is the effective after-tax interest expense at year 1?

A. 14

B. 155

C. 80

D. 21

2. Under the FTE approach, the NPV of the project is obtained by discounting future FCFE using the _______.

	A.	Cost of unlevered equity
	B.	Cost of assets
	C.	Cost of levered equity
	D.	Weighted average cost of capital

3. What is the NPV of this project?

	A.	$21
	B.	$14
	C.	$80
	D.	$155

Answer 1

1. Effective After Tax Interest Expense -

Cost of Debt = 10% * (1-tax rate) = 10% * 0.7 = 7%

Debt we have taken up is $200

After tax interest expense = $200 * 7% = $14

Answer = Option A: $14

2.Underr Flow to Equity (FTE) the cashflows are to be discounted on the cost of equity only even for a levered firm. Hence, the answer would be Option A: Cost of unlevered equity.

3.For the NPV we need to arrive at the one year discount factor. In the case of equity having cost of 20% for $1000 out of the $1200 its = (1/1.2) * (1000/1200) = 0.695

For Debt it would be = (1/1.1) * (200/1200) = 0.152

We would need to add the 2 to arrive that the discount factor for 1 year = 0.695 + 0.152 = 0.847

With this we can discount the $1600 cashflow its PV = 1600*0.847 = $1355.2

NPV = PV of Project - Cash outflow = 1355.2 - 1200 = $155.2

Answer is Option D: $155