Question

[Q18-Q23] 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%.

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

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

What is the NPV of this project?

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

Answer 1

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

here we have Free Cash Flow from equity, as the cash flow is from equity, we have to use Cost of equity to value of company's equity. Now there are two Cost of equities: Levered and Unlevered. we use Levered cost of equity because the company has long term debt in their capital structure.

Thus Cost of Levered Equity

2. NPV of project = (Cash Inflow in Year 1 - Debt - Interest * (1 - Tax)] / (1 + Cost of equity) - Cash Outflow

NPV of project = (1600 - 200 - 20 * (1 - 0.30)] / (1 + 0.20) - 1000

NPV of project = 1155 - 1000

NPV of project = $155 Option D

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