Chapter 12, Problem 49P

Cost of Capital, Net Present Value

Leakam Company’s product engineering department has developed a new product that has a 3-year life cycle. Production of the product requires development of a new process that requires a current $100,000 capital outlay. The $100,000 will be raised by issuing $60,000 of bonds and by selling new stock for $40,000. The $60,000 in bonds will have net (after-tax) interest payments of $3,000 at the end of each of the 3 years, with the principal being repaid at the end of Year 3. The stock issue carries with it an expectation of a 17.5% return, expressed in the form of dividends at the end of each year (with $7,000 in dividends expected for each of the next 3 years). The sources of capital for this investment represent the same proportion and costs that the company typically has. Finally, the project will produce after-tax cash inflows of $50,000 per year for the next 3 years.

Required:

1. 1. Compute the cost of capital for the project. (Hint: The cost of capital is a weighted average of the two sources of capital, where the weights are the proportion of capital from each source.)
2. 2. CONCEPTUAL CONNECTION Compute the NPV for the project. Explain why it is not necessary to subtract the interest payments and the dividend payments and appreciation from the inflow of $50,000 in carrying out this computation.