Cactus Cushions, a non-traditional pillow manufacturer, is considering a new cap

Question

Cactus Cushions, a non-traditional pillow manufacturer, is considering a new capital investment project that requires a $40 million investment today. Next year, the project will generate expected pre-tax cash flows of $2 million, all of which are taxable. The following year, expected cash flows will grow by 2.5%, and constant annual growth will continue forever. Assume that the project will always be backed by debt equal to 60% of the contemporaneous project value. The tax rate is 34%, debt will have required return 6%, and equity will have required return 9%. What is the project NPV according to the WACC method? Show work.

Explanation / Answer

First calculate Cost of capital using WACC method as follows

Cost of Capital = 40% * Cost of Equity + 60% * Cost of Debt ( 1-Tax)
Cost of Capital = 0.4 * 9% + 0.6 * 6% * (1-0.34) = 5.98%

Since the project is generating cash flows infinetly, calculate NPV at the end of year 1 and then discount it to the begining of year 1, i.e. year 0

After tax cash flows generated from year 1 = 2,000,000 * (1-0.34) = 1,320,000

NPV at end of year 1 using Gordon model = C / (r-g) = 1,320,000 / ( 0.0598 - 0.0250) = 37,931,034.48

Here g = expected growth which is calculated above = 5.98%

r = rate of cash flow growth = 2.5%

Discount it to year 0 = 37,931,034.48 / ( 1 + 5.98%) = -3,977,363.4

So NPV of the project is negative 3.98 million

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