Question

Orchard Farms has a pre-tax cost of debt of 7.68 percent and a cost of equity of 15.2 percent. The firm uses the subjective approach to determine project discount rates. Currently, the firm is considering a project to which it has assigned an adjustment factor of -0.5 percent. The firm's tax rate is 34 percent and its debt-equity ratio is 0.45. The project has an initial cost of $4.3 million and provides cash inflows of $1.27 million a year for 5 years. What is the net present value of the project

Answer 1

Answer:

NPV of the project 497,000

Explanation:

First, we calcualte the WACC for the firm

$WACC = K_e(\frac{E}{E+D}) + K_d(1-t)(\frac{D}{E+D})$

Ke= cost of capital= 0.152

Equity weight 0.55

Kd= cost of debt= 0.0768

Debt Weight 0.45

tax rate= 0.34

$WACC = 0.152(0.55) + 0.0768(1-0.34)(0.45)$

WACC 10.64096%

Then, we adjust for the proposed factor: (-0.5 percent)

10.64096% - 0.5% = 10.14096% This will be the project rate.

Now, we calcualte the NPV

The present value of the cash inflows:

$C \times \frac{1-(1+r)^{-time} }{rate} = PV$

C        1.27

time       5

rate       0.1014096

$1.27 \times \frac{1-(1+0.1014096)^{-5} }{0.1014096} = PV$

PV $4.7970

NPV  =  4.797 millions  -  4.3 millions  =  0.497 millions  =  $497,000