A company has a beta of 1.5. The market risk premium is 8%. The risk free rate i

Question

A company has a beta of 1.5. The market risk premium is 8%. The risk free rate is 6%. The tax rate is 40%. This company can borrow at a 10% interest rate. The D/E ratio is 1. This company is considering two mutually exclusive projects with the following net cash flows.

a.What is the WACC of this company?

b. Calculate the NPV, IRR, MIRR? (Hint: Consider both projects end in Year 7.)

c. Based on the answers to parts a and b, which project should be accepted?

d. Assume that the WACC is changed to 18%, which project should be accepted?

Year 0 1 2 3 4 5 6 7 Project A -300 -387 -193 -100 600 600 850 -180 Project B -405 134 134 134 134 134 134 0

Explanation / Answer

Answer:

(A) Calculation of WACC

D/E is 1. Hence weight of debt = Wd = 0.5 and

Weight of equity = We = 0.5

Cost of debt = Rd =0.10 * (1-0.4) = 0.06

The cost of equity is calculated as per CAPM as Re = Rf + Beta* market risk premium

Rf = 0.06

beta = 1.5 and

Market risk premium = 0.08

Hence Re = 0.06 + 1.5 *(0.08 ) = 0.18

Hence WACC = 0.5* 0.06 + 0.5*0.18 =0.12 =12%

Hence WACC = 12%

(B) The NPV, IRR and MIRR are calcuated usinf excel formulas as given below:

NPV = NPV(rate, values) rate = 0.12 (the WACC) and the values are the cash flows for the project

IRR= IRR(values). The input is just the cash flows of the project. Select all the cells with cash flows

MIRR = MIRR(values, finance_rate, reinvest_rate). here finance and reinvest rate are 0.12% since MIRR assumes that cash flows to be reinvested at an interest rate equivalent to the WACC

The results are as shown below:

(C) Based On IRR and MIRR which are more concrete and relaible we choose project B over A although A has higher NPV

(D) Wnen WACC is changed to 18%, the results are as shown

We wills still choose Project B

Year Project A Project B 0 -300 -405 1 -387 134 2 -193 134 3 -100 134 4 600 134 5 600 134 6 850 134 7 -180 0 NPV $   178.94 $   130.29 IRR 18.10% 23.97% MIRR 15.10% 17.03%

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