Store owners are considering a store addition costing $1,872,000. They expect th
ID: 2635664 • 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
Answer- Calculation of Adjusted Present Value for the project-
Cost of Equity=Rf+(Beta*Risk Premium)
=3%+.85*8%
=9.80%
Cost of Debt(after tax)=8%*.65=5.20%
Old Debt Equity Ratio=40%
New Ratio=Debt .40+.48/2=.44
Equity .60+.52/2=.56
WACC =(9.80*.56)+(5.20*.44)=7.78%
It has been assumed that Profit before tax is after deduction of Interest
EBT $ 650,000.00 $ 650,000.00 $ 650,000.00 $ 650,000.00 Less: Tax $ 227,500.00 $ 227,500.00 $ 227,500.00 $ 227,500.00 PAT $ 422,500.00 $ 422,500.00 $ 422,500.00 $ 422,500.00 Add:Depreciation $ - $ - $ - $ - Cash Flow $ 422,500.00 $ 422,500.00 $ 422,500.00 $ 422,500.00 Pvf@7.78% 0.928 0.861 0.798 0.741 Present Value $ 392,080.00 $ 363,772.50 $ 337,155.00 $ 313,072.50 Total Inflow $ 1,406,080.00 Initial Outflow $ 1,872,000.00 NPV $ (465,920.00)