Q18. BBB is about to undertake a new project. Initial outlay for the project is $1.5 billion. The project is expected to generate annual after-tax free cash flows of $65 million indefinitely. If the project has similar risk characteristics to those of BBB company as a whole, and if it could be financed with the same financing proportions that the company currently uses, what would be the project’s net present value (NPV)
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
AAA Corporation and BBB Corporation are identical in every way except their capital structures. AAA Corporation, an all-equity firm, has 45 million shares of stock outstanding, currently worth $50 per share. BBB Corporation uses leverage in its capital structure. The market value of BBB’s debt is $400mil., and its cost of debt is 3.5 percent. Each firm is expected to have earnings before interest and tax of $155mil. in perpetuity. Assume that every investor can borrow at 3.5 percent per year. Corporate tax rate is 35%.
Q18. BBB is about to undertake a new project. Initial outlay for the project is $1.5 billion. The project is expected to generate annual after-tax
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