Norris Co. has developed an improved version of its most popular product. To get this improvement to the market, will cost $48 million and will return an additional $13.5 million for 5 years in net cash flows. The firm’s debt-equity ratio is .25, the cost of equity is 13 percent, the pretax cost of debt is 9 percent, and the tax rate is 30 percent. What is the net present value of this proposed project?

$1.0725 Million

Explanation:

So now

Net Present Value =  Annuity value of the even cash inflow - Investment

Here

Investment is $48 Million

Annuity Value of $13.5 Million Cash Inflow = $13.5 Million * Annuity factor for 5 years at 11.66%

Annuity factor  = (1 -  (1 + r)^ -n) / r

Here

r is 11.66% (Step1) and n is 5 years

Annuity Factor = (1 - (1 + 11.66%)^-5) / 11.66%

Annuity Factor = 3.635

By putting values in the above equation, we have:

Net Present Value = $13.5 Million * 3.635  -  $48 Million

NPV = $1.0725 Million

Step1: Find r which Weighted average cost of capital (WACC)

Weighted Average Cost of capital  

= Value of Debt / (V of debt + V of equity) * After tax cost of debt      PLUS

(Value of equity (Value of Debt / (V of debt + V of equity)  * cost of equity

Here

Post tax cost of debt = Pre tax cost of debt * (1 + Tax rate)

Post tax cost of debt = 9% * (1- 30%) = 6.3%

The debt to equity ratio is 25% which means equity is 100% and debt is 25%.

So

Value of debt is 25%

value of equity is 100%

and total value of capital structure is 125%

This means

WACC = (25% / 125% * 6.3%) + (100% / 125% * 13%)

= 1.26% + 10.4% = 11.66%