Your company operates in the chemical industry and is now considering the addition of a new line of detergents. The project costs $$1$ million and is estimated to generate free cash flows of $$250,000$ per year for $7$ years.

The company has been financing its activities with $30\%$ debt, $10\%$ preferred stock and $60\%$ common stock. Its debt is comprised of an existing loan with a $10\%$ interest rate. The cost of preferred stock is $12\%,$ and the cost of common stock is $14\%.$ The company is subject to a $40\%$ tax rate.

Should the company invest in the new line of detergents?

Answer rating: 100% (QA)

To determine if the company should invest in the new line of detergents we can calculate the projects net present value NPV and compare it to zero First lets calculate the annual cash flowsAnnual Cash Flow Revenue Operating Costs Taxes Annual Cash Flow 250000 Operating Costs 40 250000 Since we dont have the exact operating costs lets assume they are 150000 per year thenAnnual Cash Flow 250000 150000 040 250000 100000 100000 0 Now lets calculate the NPV using the formula NPV Cash Flow 1 rn Initial Investment Where Cash Flow Annual cash flow r Discount rate weighted average cost of capital n Number of years Initial Investment 1000000 First we need to calculate the weighted average cost of capital WACC WACC Weight of Debt Cost of Debt Weight of Preferred Stock Cost of Preferred Stock Weight of Common Stock Cost of Common Stock Given Weight of Debt WD 30 Weight of Preferred Stock WP 10 Weight of Common Stock WC 60 Cost of Debt RD 10 Cost of Preferred Stock RP 12 Cost of Common Stock RC 14 WACC 030 010 010 012 060 014 003 0012 0084 0126 or 126 Now we can calculate the NPV NPV 0 1 01267 1000000 Using a financial calculator or spreadsheet we findNPV 0 11267 1000000NPV 0 70648550 70648550 Since the NPV is negative the project ... View the full answer