Question

The Excel Corp. has $1 million in corporate debt outstanding with a after-tax cost of 5%, and a maturity of two years. The only way it can finance a $500,000 investment is to refinance with $1.5 million of debt with a similar maturity, costing 8% after-tax. The investment would pay $55,000 in year 1 and $555,000 in year 2 (the investment has an IRR of .11). Assume that the current cost of equity is 12%, and that after refinancing, the firm will be 50% leveraged. Debt costs and cash flows are on an after-tax basis.

Should the investment be accepted? (You need to find out what WACC is after refinancing the debt first, and then use WACC to discount future cash flows)

Answer 1

the WACC after the refinancing will be :

now that debt and equity are in a proportion of 50,50%

the wacc will be :

0.5(12% ) + 0.5(8% ) = 10%

cash flows in year 0 = -5,00,000

cash flows in year 1 = $55,000

the present value is : $55,000/1.10 = $50,000

year 2 cash flow = $55,000

present value = $55,000/1.1^2 = $45,455

therEfore, the npv is -5,00,000 + 50,000 + 45455 = -$4,04,545

the NPV of the project is NEGATIVE after the refinncing, the IRR IS 0.11.

DUE TO THE NEGATIVE NPV THE PROJECT SHOULD BE REJECTED.

THE PROJECT WILL NOT BE ABLE TO RECOVER ITS INVESTMENT, HENCE IT SHOULD BE REJECTED.