1) Assume that a company is planning to undertake a project costing $2,000,000. This amount will be depreciated using straight line depreciation over 5 years. The project will result in increased sales of $3,000,000 a year over the next 5 years. The variable costs on increased sales will be 50% of sales and fixed costs will be $800,000 over the next 5 years. The tax rate for the company is 20%. The beta of the company is 1.25; the risk-free rate is 4% and the market risk premium is 8%. Before tax cost of debt is 9%. The company has a target capital structure of 50% debt. Assume that the company will raise the needed funds using equity and debt based on the target capital structure and future cash flows will be discounted using the weighted average cost of capital. Calculate the adjusted present value.
2) A project costs $100,000 and provides a cash flow of $40,000 every year for the next 4 years. The discount rate is 12%. This project can be taken up today or after one year. If it is taken up after one year, the project cost will increase by $50,000 but the project would provide cash flows of $55,000 a year for 4 years from the time project is taken up. The incremental NPV of delaying the project is:?
The solution examines capital budgeting, WACC, NPV and the options to delay.