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This is a part of question 1 from June 2018 exam that I can barely remember.
Company ABC is facing with decision of whether or not to carry out project E.
The company has Vd:Ve ratio as 40:60, cost of debt = 5%, wacc = 9%, risk free rate = 3%. tax rate = 20%
Cost of equity of an all equity financed company in the same business sector with project E is 12%.
So at what rate should we discount the cash flow of project E to calculate its NPV?
Also project E has 2 phase with phase 1 to be carried out now and phase 2 to be carried out after 4 (or 6, I dont remember) in the future but the implementation of phase 2 is not compulsory. The board of directors can make the decision now or after finishing phase 1. So what kind of option is that? Option to delay or to expand? at what rate should we discount phase 2?I can’t answer you properly without seeing the whole question!
As far as the discount rate it concerned, it would seem that you need to use the M&M Proposition 2 formula to calculate the relevant cost of equity, and then calculate the WACC as normal. The same discount rate to be used as well in the second part of your question.
As far as the option is concerned, it sounds like an option to expand (but again I would need to see the whole of the question).
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