O.K., Inc. uses one-third debt and two-thirds common stock to finance its operations. The after-tax cost of debt is 4.5 % and the cost of equity is 9 %. The management of O.K., Inc. is considering a small project that they consider to be equally as risky as the overall firm. The project has an initial cash outlay of $10,000. The project is expected to have a single cash inflow of $17,500 at the end of two years. What is the projected net present value of this project?

Question

Quizplus · Accepted Answer

The weighted average cost of capital (WACC) is calculated first, using the given proportions and costs: WACC = (1/3 * 4.5%) + (2/3 * 9%) = 1.5% + 6% = 7.5%. Then, the net present value (NPV) is calculated using the formula NPV = Cash inflow / (1 + WACC)^n - Initial investment, where n is the number of periods. Plugging in the values: NPV = $17,500 / (1 + 0.075)^2 - $10,000 = $5,143.32.

OK, Inc Uses One-Third Debt and Two-Thirds Common Stock to Finance