A firm is considering investing in a new project. Based on the cost of capital when using debt, preferred stock, and new common stock, the initial after-tax cost of the project is expected to be $5,000,000. 

Additionally, the project is expected to generate after-tax operating cash flows of 

$1,800,000 in Year 1, 

$2,900,000 in Year 2, 

$2,700,000 in Year 3, and 

$2,300,000 in Year 4. 

A firm has determined the optimal capital structure consisting of: sources and target market value ratios. 

Source of Capital Target Market Rates 

Long-term debt 40% 

Preferred stock 10% 

Common stock 50% 

Debt: The Firm can increase its debt by selling 15-year, $1,000 face value, 9% coupon rate bonds that pay annual interest. An IPO cost of 4 percent of face value will be required in addition to the $10 premium. 

Preferred Stock: Preferred stock can be issued regardless of the amount sold, with a value of $80 and a 12% annual dividend. The cost of issuing and selling stock is $3 per share.

 Common Stock: The firm's common stock currently sells at $10 per share. The dividend paid last year was $0.87. Dividend payments are increasing at a steady rate of 5% per year. To attract buyers, a new issue of common stock is expected to be priced under $2 per share, with the company paying $1 per share for IPO costs. 

Retained Profits: A company expects to generate earnings (net income) of US$1,000,000 to common shareholders in the coming year. The firm plans to pay 40 percent of current earnings as cash dividends. The retained earnings have already been exhausted. Therefore, the firm will use the new common stock as a form of common equity financing. Also, the firm's marginal tax rate is 40 percent.

Required

(a) The maximum acceptable payback period for this project is 3 years. Calculate the payback period for this project.

(b) Calculate the NPV of the project.

(c) Calculate the IRR of the project.

(d) Should the firm make the investment? From where?

Answer rating: 100% (QA)

To calculate the payback period NPV IRR and determine whether the firm should make the investment and from where we need to follow these steps Step 1 Calculate the Payback Period The payback period is ... View the full answer