Question

Answer Q1-4

Given the following cash flows:

Year	0	1	2	3
CF	-3,500	600	1,000	Cash flow will grow at a constant rate g=6%

We choose the following capital structure plan:

	Debt	Equity
Plan	30%	70%

Equity Benchmark:

The unlevered beta is 2, tax rate is 40%. Market Return is 16%, risk-free rate is 3%.

Debt Benchmark:

Par:100, Annual Coupon: 6%, 10-year to maturity, Selling at $88.43

Q1) What is the before-tax cost of debt

		a) 7.7%
		b)8.5%
		c)6.3%
		d)6.9%

Q2) What is the cost of equity?

		a)29%
		b)35.69%
		c)37.28%
		d)28.14%

Q3) What is the WACC?

		a)33.14%
		b)21.69%
		c)26.37%
		d)17.28%

Q4) What is the NPV of the project?

		a)1728.42
		b)917.53
		c)2231.98
		d)860.42

Answer 1

1)

Coupon = 0.06 * 100 = 6

Before tax cost of debt = 7.7%

Keys to use in a financial calculator: FV 100, PMT 6, N 10, PV -88.43, CPT I/Y

2)

Levered beta = Unlevered beta [1 + D/E(1 - tax)]

Levered beta = 2 [1 + 0.3/0.7(1 - 0.4)]

Levered beta = 2 * 1.25714

Levered beta = 2.5143

Cost of equity = Risk free rate + beta (market risk premium)

Cost of equity = 0.03 + 2.5143 (0.16 - 0.03)

Cost of equity = 0.03 + 0.32686

Cost of equity = 0.3569 or 35.69%

3)

WACC = 0.3*0.077*(1 - 0.4) + 0.7*0.3569

WACC = 0.01386 + 0.24983

WACC = 0.2637 or 26.37%

4)

Year 3 CF = 1000 * 1.06 = 1,060

Value at year 2 = CF3 / required rate - growth rate

Value at year 2 = 1060 / 0.2637 - 0.06

Value at year 2 = 5,203.73098

NPV = Present value of cash inflows - present value of cash outflows

NPV = -3500 + 600 / (1 + 0.2637)¹ + 1000 / (1 + 0.2637)² + 5,203.73098 / (1 + 0.2637)²

NPV = $860.42