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 $4.6 million. The project will provide unlevered cash flows of $685,000 per year for the next 20 years. The company will finance the project with a debt-to-value ratio of .4. The company’s bonds have a YTM of 6.9 percent. The companies with operations comparable to this project have unlevered betas of 1.16, 1.09, 1.31, and 1.26. The risk-free rate is 3.9 percent, and the market risk premium is 7.1 percent. The company has a tax rate of 35 percent. What is the NPV of this project?

Explanation / Answer

Initial investment 4.6 million Unlevered cash flow 685000 20 years Debt to value 0.4 Pre tax cost of debt 6.90% Comparable Beta 1,16 1.09 1.31 1.26 Rf 3.9% Rm-Rf 7.1% B Average (You may also take highest beta to be on the safer side) (1.16+1.09+1.31+1.26)/4 1.205 Tax 35% Cost of debt (kd) Post tax Cost of debt (6.9 x (1- 0.35)) = 4.485 Cost of equity (Ke) - Rf + (Rm- Rf) x B= 3.9 + 7.1 x 1.205 12.46 WACC = Security Weights Cost W x C (w) (c ) Debt 0.4 4.485 1.794 Equity 0.6 12.45550 7.4733 1 9.2673 WACC = 9.2673 Year 0 1 to 20 Initial Investment -4600000 Unlevered cash flow 685000 -4600000 685000 PV factor @ WACC 1 7.2612 PV of cash flows -4600000 4973906 NPV = 373905.8 No effect of interest is taken as the cost of debt is already included in WACC. Please provide feedback…. Thanks in advance…. :-)

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