Financial Management: Incremental Cash Flows, NPV, IRR, Cost of Equity and WACC

This article discusses the incremental cash flows, NPV, IRR, cost of equity and WACC for a project in Financial Management. It includes explanations, calculations and formulas for each concept.

FINANCIAL MANAGEMENT
STUDENT ID:
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Section 2
Question 1
A) The incremental cash flows from this project are indicated below.
Explanations
1) EBITDA = Revenue – Operating Expenses
2) Incremental Annual Revenue = 300500*4 + 4500*3000 = $14,702,000 = $ 14.702 million
3) Operating expenses for year 1 and year at 75% of incremental revenues while for the later
years charged at 60%.
4) EBIT = EBITDA- D&A
5) D&A = (15.3/5) = $ 3.06 million
6) (1-t) = 1-0.15 = 0.85
7) D&A is added back after net income computation since it is a non-cash charge and was
included only for the tax shield.
8) Cash flow from operations = Net income + D&A
9) Working capital initially invested in recovered at the end of the project.

B) The discount rate is given as 12% and the NPV has been computed using EXCEL and
comes out as $ 0.557 million. It can also be computed manually as shown below.
NPV = -16.8 + (3.583175/1.12) + (3.583175/1.122) + (5.45768/1.123) + (5.45768/1.124) +
(6.95768/1.125) = $ 0.557 million
Since the NPV has come out to be positive, hence the given project is feasible and must be
accepted.
C) Let the IRR of the project be X%. IRR is defined as the discount rate for which NPV is
zero.
0 = -16.8 + (3.583175/(1+X%)) + (3.583175/(1+X%)2) + (5.45768/(1+X%)3) +
(5.45768/(1+X%)4) + (6.95768/(1+X%)5)
Solving the above, we get X = 13.18%
Since IRR is greater than the discount rate of 12%, hence the given project is financially
feasible and must be accepted.
D) The cost of equity can be computed using the CAPM Approach whose equation is given
below.
Cost of equity = Risk free Rate + Beta *(Market Returns – Risk free rate)
Based on the given data,
Cost of equity for Amazon Ltd = 6 + 1.2*(8-6) = 8.4%
Pre-tax cost of debt = (1+(7%/2))2 -1 = 7.12%
Post tax cost of debt = 7.12%* (1-15%) = 6.05%
Market value of equity = Number of shares outstanding * Market price of each share =
100000*3.85 = $385,000

The par value of each bond has been assumed $100
Market value of debt = Number of bonds * Market price of each bond = 5000*0.92*100 =
$460,000
Hence, weight of equity = (385000/(385000+460000)) = 0.4556
Also, weight of debt = (460000/(385000+460000)) = 0.5444
WACC of Amazon Ltd. = 0.4556*8.4 + 0.5444*6.05 = 7.12% p.a.