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

Unlevered Cost of Equity = 12%

Since no tax rate given in the question, is is assumed to be 0%

D/E ratio after re-financing = 1 : 1(since 50% leveraged)

Levered Cost of Equity = ke*(1+D/E(1-t)) = 12%

After tax -WACC = kd*Wd*(1-t) + ke * We = 0.5* 8% + 0.5* 12% = 10%

Year 1 cash flow = $ 55,000

Year 2 Cash Flow = $ 555,000

Year 0 Cash flow = -500,000

NPV of Investment = -50000 + 55000/(1+10%) + 555000/(1+10%)^2 = $ 4,545

IRR of Investment = 10.52%

As NPV > 0 and IRR > WACC, the investment can be accepted.