Top-Down, Inc. finances its operations using $1.50 of debt for every $2 of common stock. The pre-tax cost of debt is 7.5 %, the cost of equity is 11 %, and the tax rate is 34 %. Currently, the firm is considering a small project that it considers to be equally as risky as the overall firm. The project has an initial cash outlay of $18,500 and is expected to have a single cash inflow of $25,000 at the end of year two. What is the net present value of this project?

Question

Quizplus · Accepted Answer

The net present value (NPV) of the project can be calculated by first determining the weighted average cost of capital (WACC), then discounting the future cash inflow back to its present value using this rate, and finally subtracting the initial investment.1. Calculate the weights of debt and equity:- Debt weight = $1.50 / ($1.50 + $2) = 0.4286- Equity weight = $2 / ($1.50 + $2) = 0.57142. Calculate the after-tax cost of debt:- After-tax cost of debt = Pre-tax cost of debt * (1 - Tax rate) = 7.5% * (1 - 0.34) = 4.95%3. Calculate WACC:- WACC = (Debt weight * After-tax cost of debt) + (Equity weight * Cost of equity)- WACC = (0.4286 * 4.95%) + (0.5714 * 11%) = 2.1247% + 6.2854% = 8.41%4. Calculate the present value of the future cash inflow:- PV = $25,000 / (1 + WACC)^2 = $25,000 / (1 + 0.0841)^2 ≈ $21,2735. Calculate NPV:- NPV = PV - Initial investment = $21,273 - $18,500 = $2,773Therefore, the correct answer is C) $2,773.