The large, consistently profitable firm you work for is considering a small proj

Question

The large, consistently profitable firm you work for is considering a small project. Your firm is financed by 70% equity and 30% debt. The cost of equity is 10%. The cost of debt is 5%. The risk free rate is 5%. Corporate taxes are 40%. The expected rate of return on the market is 10%. Assume CAPM is correct and the project is just as risky as your firm.

Recall; BETA(unlevered firm) = (Equity / ((Equity) + (1 - tax rate)*(DEBT))) * BETA(levered firm) The project will cost $1000 at time 0, and is expected to produce $1200 at time 1, and no other cashflows.

The firm is considering $800 debt at 6% and $200 equity to finance it.

a) What is the cost of project’s equity?, What is the WACC?, What is the NPV using WACC?

b) What is the APV, including the tax shield (show both calculations)?

c) Explain for what kinds of projects would it make most sense to use WACC vs. APV.

Explanation / Answer

a) As the project is equally risky, the cost of equity will be 10%.
WACC = [($800/$1,000) x 6%] + [($200/$1,000) x 10%] = 6.8%
NPV = -$1,000 + ($1,200 / 1.068) = $123.60

b)

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