Your firm is considering a proposed project, which lasts three years and has an
ID: 2824251 • Letter: Y
Question
Your firm is considering a proposed project, which lasts three years and has an initial investment of $200,000. The after-tax operating cash flows (OCFs) are estimated at $60,000 for year one, $120,000 for year two, and $135,000 for year three. The firm has a target debt/equity ratio of 1.2. The firm's cost of equity is 14 percent and its cost of debt is 9 percent. The tax rate is 34 percent. Please answer the following:
Calculate the profitability index. Should the firm accept the project?
Calculate the payback method. Should the firm accept the project?
Explanation / Answer
Debt/ equity =1.2/1
Debt =
We= weight of Equity=1
Ke= Cost of Equity =14% or 0.14
Wd= weight of Debt=1.2
Kd= Cost of Debt =9% or 0.09
T= tax rate =34% or 0.34
WACC= We x Ke +Wd x Kd(1-t)
= 1/ 2.2 x 0.14 +1.2/2.2 x 0.09 x (1-0.34)
=0.454545 x 0.14 + 0.545455 x 0.09 x 0.66
=0.063636 +0.0324
=0.096036
=9.60%
Year
Cashflow
PV Factor @ 9.6%
PV
0
$ (200,000)
1
$ (200,000)
1
$ 60,000
0.912
$ 54,745
2
$ 120,000
0.832
$ 99,899
3
$ 135,000
0.760
$ 102,542
NPV
$ 57,185.37
Profitability index= Initial investment + NPV/ Initial Investment
=$200,00 +$ 57,185.37 /$200,000
=$257,185.37/$200,000
=1.29
Project can be accepted as Profitability index is more than 1
Computation of Payback period
Year
Cash flow
'Cum Cash flow
0
$ (200,000)
(200,000)
1
$ 60,000
(140,000)
2
$ 120,000
(20,000)
3
$ 135,000
115,000
Payback period = 2 yrs +20,000/ 135,000
= 2 yrs +0.89 yrs
=2.89 yrs
Project can be accepted as it is recovering the investment within the project period
Year
Cashflow
PV Factor @ 9.6%
PV
0
$ (200,000)
1
$ (200,000)
1
$ 60,000
0.912
$ 54,745
2
$ 120,000
0.832
$ 99,899
3
$ 135,000
0.760
$ 102,542
NPV
$ 57,185.37
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