Question

ACS Industries is considering a project with an initial cost of $6.2 million. The project will produce cash inflows of $1.8 million a year for five years. The firm uses the subjective approach to assign discount rates to projects. For this project, the subjective adjustment is 2%. The firm has a pre-tax cost of debt of 6.7% and a cost of equity of 9.4%. The debt-equity ratio is 0.6 and the tax rate is 35%. What is the net present value of the project

Answer 1

Answer:

$0.710 million

Explanation:

The net present value of the project is the present value of future cash inflows discounted at the appropriate project discount rate minus the initial investment outlay.

The weighted average cost of capital of the firm is computed using the formula below:

WACC=(weight of equity*cost of equity)+(weight of debt*after-tax cost of debt)

debt-equity ratio=debt/equity=  0.6(which means debt is 0.6 while equity is 1 since 0.6/1=0.6)

weight of equity=equity/(equity+debt)

weight of equity=1/(1+0.6)=62.50%

weight of debt=debt/(equity+debt)

weight of debt=0.6/(1+0.6)=37.50%

cost of equity=9.4%

after-tax cost of debt=pre-tax cost of debt*(1-tax rate)

pre-tax cost of debt=6.7%

tax rate=35%

after-tax cost of debt=6.7%*(1-35%)=4.36%

WACC=(62.50%*9.4%)+(37.50%*4.36%)

WACC=7.51%

The WACC would be adjusted upward by 2% to reflect the higher level of risk of the new project

project's discount rate=7.51%+2%=9.51%

present value of a future cash flow=future cash flow/(1+discount rate)^n

n is the year in which the future cash flow is expected, it is 1 for year 1  cash flow ,2 for year 2 cash flow, and so on.

NPV=$0.710 million($710,000)