Store owners are considering a store addition costing $1,872,000. They expect th
ID: 2635663 • Letter: S
Question
Store owners are considering a store addition costing $1,872,000. They expect the new addition to generate pre-tax cash flows of $650,000 for each of the next four years. The current debt to value ratio of the store is 40% and the addition will be partially financed with an $900,000 bond paying a coupon of 8%, which is the current cost of debt for the store. Assume the bond has a 5 year maturity. Ignoring depreciation, find the Adjusted Present Value for the project. You may use the following data.
The marginal tax rate is 35%.
The risk-free rate is 3.0%.
The equity beta is 0.85.
The market risk premium is 8.0%.
Explanation / Answer
Cost of Equity=3+0.85*(8-3) 7.25 Cost of Debt=(1-0.35)*8 5.2 Investment Proposed 1872000 Debt component of investment 900000 Equity Component=(1872000-900000) 972000 Posttax Cash inflow for 4years@(1-0.35)*650000 422500 D/E=40/60 Tax Rate 35% WACC=(900000*5.2+972000*7.25)/(1872000) 6.264 APV=422500/(1.06264^1)+422500/(1.06264^2)+422500/(1.06264^3)+422500/(1.06264^4)-1872000 -416800 The D/E ratio will change after this investment of 1.872000 as this investment is not in the proportion of 40/60