Frieda Inc. is considering a capital expansion project. The initial investment o
ID: 2702274 • Letter: F
Question
Frieda Inc. is considering a capital expansion project. The initial investment of undertaking this project is $105,500. This expansion project will last for five years. The net operating cash flows from the expansion project at the end of year 1, 2, 3, 4 and 5 are estimated to be $22,500, $25,800, $33,000, $45,936 and $58,500 respectively.
Frieda has a capital structure consisting of 20% debt and 80% equity. The after-tax cost of debt is 16% and the cost of equity is 18.5%.
What is Frieda%u2019s weighted average cost of capital? size="2">
16%
18%
24%
22%
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Explanation / Answer
What is Frieda weighted average cost of capital?
WACC = Kd*Wd*(1-t) + We*Ks.
SO WACC = 20%*16% + 80%*18.5% = 18.00%
Continued from Question 29, based on Frieda weighted average cost of capital calculated, what is the NPV of undertaking this expansion project? That is, what is the NPV if the weighted average cost of capital is used as the discount rate
NPV = NPV(Rate,CF1...CF5) + CF0
ie NPV = NPV(18%,22500,25800,33000,45936,58500) - 105500
ie NPV = $1,445.94
Based on the NPV obtained in Question 30, shall Frieda undertake the expansion project?
Yes, because NPV>0
Continued from Question 29, based on Frieda weighted average cost of capital calculated, what is the profitability index of undertaking this project? That is, what is the profitability index if the weighted average cost of capital is used as the discount rate?
PI = PV of CFs/Initial Inv
= NPV(18%,22500,25800,33000,45936,58500)/105500
= 1.01
Based on the Profitability Index (PI) obtained in Question 32, shall Frieda undertake the expansion project?
Yes, because PI >1
Continued from Question 29, what is the internal rate of return (IRR) if Frieda undertakes this project?
IRR = IRR(CFs) = IRR(-105500,22500,25800,33000,45936,58500)
ie IRR = 18.51%
Based on IRR obtained in Question 34, shall Frieda undertake this project? Assuming the weighted average cost of capital (calculated in Question 29) is the appropriate discount rate for the capital budgeting problems considered.
Yes, IRR > Weighted Average Cost of Capital.
Continued from Question 29, what is the modified internal rate of return if Frieda undertakes this project. Assuming that the positive cash inflow from undertaking this project will be reinvested at the weighted average cost of capital calculated in Question 29.
MIRR = MIRR(CFs, CF0,WACC)
= MIRR(22500,25800,33000,45936,58500,-105500,18%)
= 18.32%
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