Calculate the NPV of a project given the following - and should the company acce

Question

Calculate the NPV of a project given the following - and should the company accept or reject the project: It is estimated that the project will deliver $25,000 operating profit each year for 12 years. The firm can borrow as much as they like from their bank (which is being bailed out by the Federal Government - bless 'em) at 10%. They have no retained earnings available - they are paying all their net profit out in dividends at $2.00 per share (I never said this was a well run company) They can sell stock at $20.00 with a flotation cost of $4.00 per share. The stock's earnings/dividends are growing at 6% They are in a 40% marginal tax bracket. The Board of Directors has determined a target capital structure of 60% debt and 40% common equity. - they have no preferred stock. The machine they are considering costs $160,000. And for the last time, be sure to show all work and formulas! You've been warned!

Explanation / Answer

Cost of New Equity = D1/(Stock Price - Flotation Cost) + growth rate

Cost of New Equity = 2*1.06/(20-4) + 6%

Cost of New Equity = 19.25%

After tax cost of debt = 10*(1-40%)

After tax cost of debt = 6%

WACC = 19.25*40% + 6*60%

WACC = 11.30%

Annual Depreciation =160000/12 = 13333

Annual Cash Flow = operating profit *(1-tax rate) + Annual Depreciation*tax rate

Annual Cash Flow = 25000*(1-40%) + 13333*40%

Annual Cash Flow = 20333.33

NPV = -Initial Investment + Annual Cash Flow*(1-(1+r)^-n)/r)

NPV = -160000+ 20333.33*(1-(1+11.30%)^-12)/11.30%

NPV = -29,854.30

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