Please see image for question. Consider the following project. Replacement of ol
ID: 2792679 • Letter: P
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Please see image for question.
Consider the following project. Replacement of old equipment for newer and more efficient equipment is expected to yield annual total after-tax cost savings (including any tax shields from depreciation) resulting in operational cash flows of $14 million for 12 years, starting at t=1. The new equipment has a cost of $80 million and is depreciated over 10 years according to straight-line methodology. The salvage value at t=12 is $15 million. The corporate tax rate is 30% and the firm has a target debt-to-equity ratio of 0.5, Creditors require 12% return on their debt and the equity beta of the firm is 1.8. The expected return on the S&P; 500 index is 12% and on a t-bill is 496. a. What are the relevant cash flows in each year, i.e, t (0, 12)? b. What is the firm's target debt-to-value (leverage) ratio? c. What is the firm's cost of equity? d. What is the firm's cost of debt? e. What is the weighted average cost of capital (Rwacc)? f. What is the beta for the entire firm- not just its equity? 8. What is the NPV of this project and should they accept?Explanation / Answer
a. Relevant cash flows Millions t=0 -80 t=1 to 12 14 t=12 15*(1-30%) 10.5 b. Firm's Target Debt/Equity ratio= 0.5 Ie. Debt=0.5 & Equity=1 Firm's value=Debt+Equity=0.5+1=1.5 So, Firm's target Debt to value=0.5/1.5=0.33 c. Firm's cost of Equity,Ke= Ke=RFR+(Beta*Market Risk Premium) Ke=4%+(1.8*(12%-4%)) 18.40% d.Firm's After-tax cost of Debt 12%*(1-30%)= 8.40% e. Wt. Av. Cost of capital (66.67%*18.40%)+(33.33%*8.40%)= 15.07% f. Ullevered Beta=Lev.Firm Beta/(1+((1-Taxrate)*(Debt/equity))) 1.8=Lbeta/(1+((1-30%)*(0.50/1))) Solving the above Beta of entire firm = 2.43 g. NPV of the project at 15.07% WACC -80+(14*5.40446)+(10.5*0.18555) -2.38929 The project cannot be accepted because of the NEGATIVE NPV. PV factors PVOA,F 15.07%, 12 yrs.=5.40446 PV F 15.07%, 12 yrs.
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