The 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 NPV is: a) +33 percent 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 Hi guys all your help is greatly appreciated. I am a first time poster and I also failed Jun 08 and plan to kill it Dec 08. My performance band was 9

answer is c

wacc= .05*.67*.09+.15*.5=1.078015 cf0=-5000 cf1…cf8=1000 after discounting all values you will get -33.964(hence -ve npv, do not accept the project

WACC = D/(D+E) x rd x (1-tax) + E/(D+E) x re = 50/150 x .09 x .67 + 100/150 x .15 = 0.12 Required rate = 12% N = 8 I = 12 PMT = -1000 FV = 0 CPT PV = 4967.639767 NPV = -5000 + 4967.639767 = - 32.360233 ~ = - 33 ( negative don’t accept !!) C is the answer !!

Bee can you please explain why you used 150 in the denominator in calculating the wd and we.

because Wd = percentage of debt in capital structure We = percentage of equity in capital structure Capital structure = Debt + Equity so Wd = debt / total capital structure = debt / ( debt + equity) similarly for We.

Wd = percentage of debt in capital structure = D / (D+E) We = percentage of equity in capital structure = E / (D+E) Capital structure = Debt + Equity so Wd = debt / total capital structure = debt / ( debt + equity) similarly for We. Now :- D/E = 50/100 …given E/D = 100/ 50 Now inverse of ( D/E + 1) = E/(D+E) = 100/150 inverse of ( E/D + 1 ) = D/(D+E) = 50/150

Another way that is intuitive: d + e =1 d/e=.5 (given in problem) d = .5e .5e + e =1 1.5e = 1 e = 1/1.5 e = .66667 d = .33333

Thanks for all your help. I get it now.

More elaboration on the total capital structure being 150 is greatly appreciated. If D/E = .5 then E = 1 So D + E = .5 + 1 = 1.5, right? 1.5 is the denominator for weight in debt, and weight in equity. Is that the correct logic?

D/E = 1/2 Then, D=1 and E=2 Wd = 1/3 and We=2/3 WACC = D/(D+E) x rd x (1-tax) + E/(D+E) x re = 1/3x.09x.67 + 2/3x.15 =.12

JRBBIKERX, D/E=.5;D=0.5 *E D +E=1; 0.5E +E=1; E= 1/1.5 =0.66 (WEIGHT OF EQUITY) D+ 0.66=1; SO D= 0.33(WEIGHT OF DEBT) WACC= 0.33 *0.09 * (1-.33) + 0.67 *.15=0.0198+ 0.1005= 0.1203 I.E, 1.12

Yes, i got it. THanks,.