A company has asked you to double check the Net Present Value analysis for a 10-year project. The…

A company has asked you to double check the Net Present Value analysis for a 10-year project. The company estimated a Net Present Value of £2 million for the project. To arrive at this value, it discounted the after-tax operating profits with its unlevered cost of equity, and ignored working capital requirements. The project is expected to generate constant after-tax operating profits for the next 10 years. The initial capital investment required is £50 million, which would be depreciated straight line over 10 years to a salvage value of zero. You estimate that the project requires non-cash working capital of £5 million, which would be fully recovered once the project has ended. The company correctly calculated that its unlevered cost of equity is 10%. However, it has a debt-to-assets ratio of 1/3 and a pre-tax cost of debt of 6%. Assume that the corporation tax rate is 25%. Requirements:

(a) Estimate the discount rate that the company should have used to discount the future cash flows.

(b) Estimate the annual after-tax operating profit from the company’s original Net Present Value calculation.

(c) Assume that the company’s estimate of the annual after-tax operating profit was correct. Estimate the correct Net Present Value of the project, with all the cash flows considered and using the correct discount rate. [You need parts (a) and (b) to do part (c). If you have trouble with parts (a) and (b), use 10% as your discount rate and £10 million as your annual after-tax operating profit.]

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