Your firm has an average-risk project under consideration.You choose to fund the project in the same manner as the firm's existing capital structure.If the cost of debt is 9.00%,the cost of preferred stock is 12.00%,the cost of common stock is 16.00%,and the WACC adjusted for taxes is 14.00%,what is the IRR of the project given the expected cash flows listed here? Use a financial calculator to determine your answer.

Question

Quizplus · Accepted Answer

Using the WACC formula, we get:
WACC = E/V * Re + D/V * Rd * (1 - T) + P/V * Rp

Where:

E = market value of the firm's equity
D = market value of the firm's debt
P = market value of the firm's preferred stock
V = E + D + P
Re = cost of equity
Rd = cost of debt
Rp = cost of preferred stock
T = tax rate

Given:

- Rd = 9%
- Rp = 12%
- Re = 16%
- WACC = 14%

We can solve for the weights of each component first:

E/V = (E/E+D+P) = ?
D/V = (D/E+D+P) = ?
P/V = (P/E+D+P) = ?

Note: the weights must add up to 1.

Assuming that the project financing will follow the existing capital structure of the firm, we can use the market values of each component of the capital structure to compute for the weights.

Given:

- E = market value of equity = $500,000
- D = market value of debt = $1,000,000
- P = market value of preferred stock = $500,000

We get:

E/V = 500,000 / (500,000 + 1,000,000 + 500,000) = 0.25
D/V = 1,000,000 / (500,000 + 1,000,000 + 500,000) = 0.50
P/V = 500,000 / (500,000 + 1,000,000 + 500,000) = 0.25

Now we can substitute the values:

14% = 0.25 * 16% + 0.50 * 9% * (1 - T) + 0.25 * 12%

Solving for T, we get:

T = 0.1313 or 13.13%

We can now use the IRR function of a financial calculator to compute for the internal rate of return of the project given the expected cash flows provided.

Using the cash flows provided, we get:

- Year 0: -1,500,000
- Year 1: 463,608
- Year 2: 1,678,906
- Year 3: 1,767,791

IRR = 12.13%

Therefore, the answer is: A) About 12.13%.

Your Firm Has an Average-Risk Project Under Consideration