Your firm is considering a proposed project which lasts 3 years and has an initi

ID: 2767438 • Letter: Y

Question

Your firm is considering a proposed project which lasts 3 years and has an initial investment of 200,000. The after-tax operating cash flows (OCFs) are estimated at $60,000 for year 1, $120,000 for year 2, and $135,000 for year 3. The firm has a target debt/equity ratio of 1.2. The firm's cost of equity its 14% and it cost of debt is 9%. The tax rate is 34%, please answer the following: a. Calculate the Net Present Value. Should the firm accept the project? b. Calculate the Profitability Index (CFin/CF out). Should the firm accept the project? c. Calculate the payback method. Should the firm accept the project? d. Does the firm's debt-to-equity impact on the outcome of your decision? Why?

Explanation / Answer

Minimum acceptable rate of return (MARR):

Source

Before-tax cost (%)

After-tax cost (%) (A)

Capital proportion (B)

MARR (A × B)

Equity

1/2.2

6.36

Debt

9 × (1 – 0.34) = 5.94

1.2/2.2

3.24

9.6

NPV = Present value of cash inflows – Initial investments

= 60,000/(1+0.096) + 120,000/(1 + 0.096)^2 + 135,000/(1 + 0.096)^3 – 200,000

= 54,744.53 + 99,898.77 + 102,542.08 – 200,000

= $57,185.38

The project should be accepted, since the NPV is positive.