Platinum Water Aviation has a weighted-average cost of capital of 10.36 percent
ID: 2617127 • Letter: P
Question
Platinum Water Aviation has a weighted-average cost of capital of 10.36 percent and is evaluating two projects: A and B. Project A involves an initial investment of 4,886 dollars and an expected cash flow of 8,404 dollars in 4 years. Project A is considered more risky than an average-risk project at Platinum Water Aviation, such that the appropriate discount rate for it is 1.01 percentage points different than the discount rate used for an average-risk project at Platinum Water Aviation. The internal rate of return for project A is 14.52 percent. Project B involves an initial investment of 6,398 dollars and an expected cash flow of 9,917 dollars in 7 years. Project B is considered less risky than an average-risk project at Platinum Water Aviation, such that the appropriate discount rate for it is 1.78 percentage points different than the discount rate used for an average-risk project at Platinum Water Aviation. The internal rate of return for project B is 6.46 percent. What is X if X equals the NPV of project A plus the NPV of project B?
Explanation / Answer
For project A
Initial Investment = $4,886
Return in year 4 = $8,404
Average discount rate = 10.36%.
Risk adjusted discount rate for project A = 10.36% + 1.01%
= 11.37%
Risk adjusted discount rate for project A is 11.37%.
NPV of project A = [$8,404 / (1 + 11.37%) ^ 4] - $4,886
= ($8,404 / 1.5384) - $4,886
= $5,462.77 - $4,886
= $576.77
NPV of project A is $576.77.
For project B
Initial Investment = $6,398
Return in year 7 = $9,917
Average discount rate = 10.36%.
Risk adjusted discount rate for project B = 10.36% - 1.78%
= 8.58%
Risk adjusted discount rate for project B is 8.58%.
NPV of project B = [$9,917 / (1 + 8.58%) ^ 7] - $6,398
= ($8,404 / 1.7793) - $6,398
= $5,573.54 - $6,398
= -$824.46
NPV of project B is -$824.46.
Value of X = NPV of project A + NPV of project B
= $576.77 - $824.46
= -$247.69
Value of X is -$247.69.