could someone help me out with the below? How is this derived? A firm is considering a $5,000 project that will generate an annual cash flow of $1,000 for the next 8 years. The firm has the following financial data: Debt/equity ratio is 50 percent. Cost of equity capital is 15 percent. Cost of new debt is 9 percent. Tax rate is 33 percent. The project’s net present value (NPV) is: A) +$33, so accept the project. B) -$4,968, so don’t accept the project. C) -$33, so don’t accept the project. D) +$4,968, so accept the project. Your answer: A was incorrect. The correct answer was C) -$33, so don’t accept the project. First, calculate the weights for debt and equity wd + we = 1 wd= 0.50We 0.5We+We = 1 wd = 0.333, we = 0.667 Im not quite sure how they come up with Wd = .333 and We = .667
D+E=A, D/E=0.5 => D=0.5E 0.5E+E=A => 1.5E = A, divide both parts by A, 1.5 we = 1 , we = 1/1.5=0.667; wd = 1-we = 0.333
why do you have .5E+E = A, shouldn’t it be .5E + D = A? Im still kinda lost…
D/E=0.5, multiply both sides with E, that’s D=0.5E. Replace D in D+E=A
Here’s the “math free” way (not a good idea for finance people, but if it get s the point across, what the heck): Set E to 100 ==> D = 100(.5)=50 A=D+E = 150. So, D/(D+E) = 50/150 = 0.333
isn’t it because you dont pay taxes on equity? You calculate debt as 1-T but you dont do that with stock.
No, is not. The weight of Debt and weight of Equity in the capital structure has nothing to do with taxes, but with the cost of capital, the rate used as discount interest rate when you calculate NPV. Discount interest rate used to calculate NPV: (1-t)*wd*Cost of new debt +we*Cost of new equity
D/E=.5, so there is 2x more equity than debt. D + 2D = 1.0 1/3 = .333 = D 2D = .667
Think about it this way: There are two parts equity and one part debt ( d/e = 1/2). That makes three parts total. Debt represents 33.3% in the weighting because it is one part out of three. Edit: It is also important to remember that in the D/E ratio, the denominator is not the total amount of both debt and equity combined, it is only the amount of equity. Thus, the weighting won’t be .5
another way to culculate weight is just .5/1.5=.3333 for debt and 1-.3333 for equity. tha question was a good refresher i was equally tempted to weigh the two by .5 each.
AudreyMwala Wrote: ------------------------------------------------------- > another way to culculate weight is just > .5/1.5=.3333 for debt and 1-.3333 for equity. tha > question was a good refresher i was equally > tempted to weigh the two by .5 each. is this question a good example of a CFA exam
I might be asking a stupid question - but why do you calculate the weights for debt and equity if the question asks for NPV? Thank you
I got banged proper on an exactly similar Q too. and “gogiants” , here you go mate: “The NPV method uses the weighted average cost of capital (WACC) as the appropriate discount rate.” i was surprised to NOT remember this (in connection to some other QUESTION) but again think practically, WACC is the actual cost of capital isn’t it ? That is, the " I " for calculating NPV ?
am i missing something here? .333 [.09(.67)] + .667 (.15) = 12.05% ? when i put this into a CF model on the calculator beginning with -5,000 CF0 and 1,000 CF1 - 8, i come up with -41 i guess (hope) on the test i’d be inclined to answer C) because its closest to my answer… but does anyone know what i’m doing wrong?
The actual number will vary from 32 up to the 40s depending on how many 3s and 6s you put in your initial calculation. Do it again with .3333333333333 and .66666666666666 and you’ll get exactly .12 as your WACC.
Echoing the points mentioned in this thread, using your calculators, it works out to: N: 8 PMT: 1000 I: 12.01 (equity 10% + debt 2.01%) FV: 0 PV = 4 966 4966 - 5000 = (34) Debt is 1/3 of overall R, while Capital is 2/3.