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Computers is considering a new project that costs of I = $5 million
Computers is considering a new project that costs of I = $5 million. The project will generate after-tax (year-end) cash flows of $1.5 million for ten years. The firm has a debt-to-equity ratio of D/E = 3/7. The equity beta for Acme is ß = 1.5. The expected return on the market is E[RM] = 10 percent and the risk-free rate is RF = 4 percent. The before-tax cost of debt is kd = 11 percent. The corporate tax rate is T = 40 percent. Calculate the weighted average cost of capital (WACC) and the NPV of this project 10.257% and $4,115,965.56 11.08% and $3,804,292.71 12.4% and $3,338,344.23 11.08% and $8,804,292.71
Expert Solution
| D/A = D/(E+D) |
| D/A = 0.428571428571429/(1+0.428571428571429) |
| =0.3 |
| Weight of equity = 1-D/A |
| Weight of equity = 1-0.3 |
| W(E)=0.7 |
| Weight of debt = D/A |
| Weight of debt = 0.3 |
| W(D)=0.3 |
| Cost of equity |
| As per CAPM |
| Cost of equity = risk-free rate + beta * (expected return on the market - risk-free rate) |
| Cost of equity% = 4 + 1.5 * (10 - 4) |
| Cost of equity% = 13 |
| After tax cost of debt = cost of debt*(1-tax rate) |
| After tax cost of debt = 11*(1-0.4) |
| = 6.6 |
| WACC=after tax cost of debt*W(D)+cost of equity*W(E) |
| WACC=6.6*0.3+13*0.7 |
| WACC =11.08% |
| Project | |||||||||||
| Discount rate | 0.1108 | ||||||||||
| Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 |
| Cash flow stream | -5000000 | 1500000 | 1500000 | 1500000 | 1500000 | 1500000 | 1500000 | 1500000 | 1500000 | 1500000 | 1500000 |
| Discounting factor | 1 | 1.1108 | 1.233877 | 1.37059 | 1.5224516 | 1.691139 | 1.878517 | 2.086657 | 2.317859 | 2.574678 | 2.859952 |
| Discounted cash flows project | -5000000 | 1350378 | 1215681 | 1094419 | 985253.02 | 886976.1 | 798502 | 718853.1 | 647149 | 582597.2 | 524484.4 |
| NPV = Sum of discounted cash flows | |||||||||||
| NPV Project = | 3804292.71 | ||||||||||
| Where | |||||||||||
| Discounting factor = | (1 + discount rate)^(Corresponding period in years) | ||||||||||
| Discounted Cashflow= | Cash flow stream/discounting factor | ||||||||||
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