Your firm is considering a proposed project which lasts thre

Your firm is considering a proposed project, which lasts three years and has an initial investment of $200,000. The after-tax operating cash flows (OCFs) are estimated at $60,000 for year one, $120,000 for year two, and $135,000 for year three. The firm has a target debt/equity ratio of 1.2. The firm\'s cost of equity is 14 percent and its cost of debt is 9 percent. The tax rate is 34 percent. Please answer the following:

Calculate the profitability index. Should the firm accept the project?

Calculate the payback method. Should the firm accept the project?

Solution

Debt/ equity =1.2/1

Debt =

We= weight of Equity=1

Ke= Cost of Equity =14% or 0.14

Wd= weight of Debt=1.2

Kd= Cost of Debt =9% or 0.09

T= tax rate =34% or 0.34

WACC= We x Ke +Wd x Kd(1-t)

           = 1/ 2.2 x 0.14 +1.2/2.2 x 0.09 x (1-0.34)

          =0.454545 x 0.14 + 0.545455 x 0.09 x 0.66

        =0.063636 +0.0324

       =0.096036

      =9.60%

Year

Cashflow

PV Factor @ 9.6%

PV

0

$     (200,000)

1

$    (200,000)

1

$       60,000

                   0.912

$      54,745

2

$      120,000

                   0.832

$      99,899

3

$      135,000

                   0.760

$     102,542

NPV

$ 57,185.37

Profitability index= Initial investment + NPV/ Initial Investment

                        =$200,00 +$ 57,185.37 /$200,000

                        =$257,185.37/$200,000

                        =1.29

Project can be accepted as Profitability index is more than 1

Computation of Payback period

Year

Cash flow

\'Cum Cash flow

0

$     (200,000)

               (200,000)

1

$       60,000

               (140,000)

2

$      120,000

                (20,000)

3

$      135,000

                115,000

Payback period = 2 yrs +20,000/ 135,000

                        = 2 yrs +0.89 yrs

                         =2.89 yrs

Project can be accepted as it is recovering the investment within the project period

Year	Cashflow	PV Factor @ 9.6%	PV
0	$     (200,000)	1	$    (200,000)
1	$       60,000	0.912	$      54,745
2	$      120,000	0.832	$      99,899
3	$      135,000	0.760	$     102,542
		NPV	$ 57,185.37