# Calculating WACC and then NPV of Projects

Question 1

A company has a capital structure composed by 20% Debt and 80% Equity. The cost of the debt is 5% per year while the cost of equity is 15% per year.

The company is considering two different projects. The cash flows of the two projects are reported in the table below.

Please see attached.

A company has a capital structure composed by 20% Debt and 80% Equity. The cost of the debt is 5% per year while the cost of equity is 15% per year.

The company is considering two different projects. The cash flows of the two projects are reported in the table below.

Time Project A Project B

0 ($120,000) ($150,000)

1 $25,000 $38,000

2 $35,000 $38,000

3 $50,000 $50,000

4 $50,000 $50,000

5 $35,000 $50,000

a) Compute the NPV of each project.

b) Which project the company should accept? Explain.

Question 2

The company LL has a capital structure composed by 30% of debt and 70% of equity and is planning to invest in a new industry.

Following the standard technique in Corporate Finance, the financial manager of the company finds that the two main pure plays of the new industry have the following characteristics.

Company PP Company CC

Stock Beta 0.80 1.00

Fraction of Debt 0.25 0.40

Fraction of Equity 0.75 0.60

Assume the expected return on the market is 8% while the risk free rate of interest is 3% per annum. The company pays a 4.5% rate for the debt.

Compute the WACC of this project. [Hint: Carefully explain each step you need to compute the WACC.]

Question 3

Assume you are considering and investment in a project that requires an initial outlay of $225,000 and will produce after-tax cash flows of $35,000 per year for the next 15 yrs. Your firm uses 50% debt and 50% equity in its financing. The after-tax cost of the debt and equity are 9% and 15% respectively.

a) What is the project WACC?

b) What is the project NPV? Should the project be accepted?

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#### Solution Preview

Answers are in the attached files

A company has a capital structure composed by 20% Debt and 80% Equity. The cost of the debt is 5% per year while the cost of equity is 15% per year.

The company is considering two different projects. The cash flows of the two projects are reported in the table below.

Time Project A Project B

0 ($120,000) ($150,000)

1 $25,000 $38,000

2 $35,000 $38,000

3 $50,000 $50,000

4 $50,000 $50,000

5 $35,000 $50,000

a) Compute the NPV of each project.

The NPV is calculated in the excel sheet. The discounting rate is the WACC and is calculated from the given proportion of debt and equity and the cost given. The NPV of Project A is $13,849 and of Project B is $5,844

b) Which project the company should accept? Explain.

Both ...

#### Solution Summary

The solution explains how to calculate the WACC and then use it to calculate the NPV of projects

Finance Case: Calculate WACC, NPV, PI, IRR and MIRR

See also enclosed Word document of the case study and excel spreadsheet for the financial exibit. Please help answer all questions.

The Investment Detective

The essence of capital budgeting and resource allocation is a search for good investments in which to place the firm's capital. The process can be simple when viewed in purely mechanical terms, but a number of subtle issues can obscure the best investment choices. The capital budgeting analyst is necessarily, therefore, a detective who must winnow good evidence from bad. Much of the challenges is knowing what quantitative analysis to generate in the first place.

Supposed you are a new capital budgeting analyst for a company considering investments in the eight projects listed in Exhibit 1. The chief financial officer of your company has asked you to rank the projects and recommend the "four best" that the company should accept.

Part I

For the first part of this assignment only quantitative considerations are relevant. No other project characteristics are deciding factors in the selection, except that management has determined that projects 7 and 8 are mutually exclusive.

All projects require the same initial investment, $2,000,000. Moreover, all are believed to be of the same risk class. The weighted average cost of capital for the first part is 10%. To simulate your analysis, consider the following questions:

1. Can you rank the projects simply by inspecting the cash flows?

2. What criteria might you use to rank the projects? Which quantitative ranking methods are better? Why?

3. What is the ranking you found by using quantitative methods? Does this ranking differ from the ranking obtained by simple inspection of the cash flows?

4. What kinds of real investment projects have cash flows similar to those in the exhibit?

Part II

The company has the following capital structure:

Account $ Costs before tax

Long-term Debt 2,000,000 10%

Preferred Stock 500,000 14%

Common Stock 2,500,000 16%

1. Calculate the weighted average cost of capital (tax is 36%)

2. Using the same cash flows in exhibit I, find the NPV, PI, IRR and MIRR. Which project(s) would you recommend and why?