Dorman Industries has a new project available that requires an initial investmen

Question

Dorman Industries has a new project available that requires an initial investment of $5.5 million. The project will provide unlevered cash flows of $775,000 per year for the next 20 years. The company will finance the project with a debt-to-value ratio of .25. The company’s bonds have a YTM of 6.5 percent. The companies with operations comparable to this project have unlevered betas of 1.25, 1.18, 1.40, and 1.35. The risk-free rate is 3.5 percent, and the market risk premium is 6.7 percent. The company has a tax rate of 35 percent.

What is the NPV of this project? (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Explanation / Answer

Beta of unlevered firm = (1.25 + 1.18 + 1.40 + 1.35) / 4 = 1.295

D/V = 25%, E/V = 1 - 25% = 75%, D/E = 1/3

Beta of levered firm = Unlevered beta x [1 + (1 - tax) x D/E] = 1.295 x (1 + (1 - 35%) x 1/3) = 1.576

Cost of equity, ke = Rf + beta x MRP = 3.5% + 1.576 x 6.7% = 14.06%

WACC = wd x kd x (1 - tax) + we x ke

= 25% x 6.5% x (1 - 35%) + 75% x 14.06%

= 11.60%

PV of future cash flow can be calculated using PV formula

N = 20, I/Y = 11.6%, PMT = 775,000, FV = 0 => Compute PV = $5,937,603.43

NPV = 5,937,603.43 - 5,500,000 = $437,603.43

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