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?
2. Under the FTE approach, the NPV of the project is obtained by discounting future FCFE using the _______.
Cost of unlevered equity
Cost of assets
Cost of levered equity
Weighted average cost of capital
3. What is the NPV of this project?
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
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