Assessing Methodologies

Corporate Finance WACC = ((E/V) * Re) + [((D/V) * Rd)*(1-T)] where E = Market value of the company's equity D = Market value of the company's debt V = Total Market Value of the company (E + D) Re = Cost of Equity Rd = Cost of Debt T= Tax Rate In this case, we have the following values for these parameters: E/V = percentage of equity to finance the project = 60% D/V = percentage of debt to finance the project = 40% Re = Cost of Equity = required return by stockholders = 18.36% Rd = Cost of Debt = required return by debt holders = 10.68% T= Tax Rate = 36% = 0.36 As such, WACC = ((0.6) * 0.1836) + [((0.4) * 0.1068)*(1-0.36)] = 0.027 = 2.7% The firm's weighted average cost of capital is 2.7%.

b. The Net Present Value is calculate according to the formula below. Here, the discount rate (r) is equal to the weighted average cost of capital. So, r = 2.7% = 0.027 The initial investment (C0) is equal to the cost of the project, which is $45,000. The cash flows C. are each equal to $13,000 for the next 20 years. So, T = 20. The formula now becomes NPV = C x (1 ? (1 + r)-T) Initial Investment NPV = $13,000 X (1-1.027-20) - $45,000 = -$35,851 The project should not be undertaken. c.

, with the following explanations: is the required rate of return on equity, or cost of levered equity is the company cost of equity capital with no leverage is the required rate of return on borrowings, or cost of debt. is the debt-to-equity ratio. is the tax rate In this case, we have the following values: D/E = 40/60=2/3 Rd = 10.68% = 0.1068 Re = 18.36% = 0.1836 Tc = 36% = 0.36 R0 = required return on unlevered equity As such, R0 = 0.229 d.

APV = NPV (Unlevered) + NPV (Financing effects) We need to discount the cash flows from the case study ($13,000 a year) at a rate that would reflect an all-equity financed project. The discount rate is R0, calculated according to the M&M Proposition II at the previous point. The discount rate is 0.229 So, we can now calculate the NPV (Unlevered) as $13,000 X (1-1.229-20) - $45,000 = -$32,210. However, now we also need to calculate the debt tax shields.

The annual tax shield = 40% X 18,000 (40% of the total cost of the project) X 36% = $2,592 The present value of tax savings can.