i = rdebt = 6% OCF0 = −$100,000

Ku = rassets = 12% OCF1-4 = $39,800 = 25,000 × ($5 − $3) × (1 − 0.34) + $20,000 × 0.34
Kl = requity = 27.84% OCF5 = $43,100 = $39,800 + $5,000 × (1 − 0.34)
K = rWACC = 8.74% π = Tax rate = 34% Debt-to-equity ratio = 4 Risk-free rate = 2%

The 5-year project requires equipment that costs $100,000. If undertaken, the shareholders will
contribute $20,000 cash and borrow $80,000 at 6 percent with an interest-only loan with a
maturity of 5 years and annual interest payments. The equipment will be depreciated straight-line
to zero over the 5-year life of the project. There will be a pre-tax salvage value of $5,000. There
are no other start-up costs at year 0. During years 1 through 5, the firm will sell 25,000 units of
product at $5; variable costs are $3; there are no fixed costs.

What is the NPV of the project using the WACC methodology?

i = rdebt = 6% OCF0 = −$100,000
Ku = rassets = 12% OCF1-4= $39,800 = 25,000 × ($5 − $3) × (1 − 0.34) + $20,000 × 0.34
Kl = requity = 27.84% OCF5 = $43,100 = $39,800 + $5,000 × (1 − 0.34)
K = rWACC = 8.74% π = Tax rate = 34% Debt-to-equity ratio = 4 Risk-free rate = 2%

The 5-year project requires equipment that costs $100,000. If undertaken, the shareholders will
contribute $20,000 cash and borrow $80,000 at 6 percent with an interest-only loan with a
maturity of 5 years and annual interest payments. The equipment will be depreciated straight-line
to zero over the 5-year life of the project. There will be a pre-tax salvage value of $5,000. There
are no other start-up costs at year 0. During years 1 through 5, the firm will sell 25,000 units of
product at $5; variable costs are $3; there are no fixed costs.

What is the NPV of the project using the APV methodology?

Consider a project of the Cornell Haul Moving Company, the timing and size of the incremental
after-tax cash flows (for an all-equity firm) are shown below in millions:

The firm's tax rate is 34 percent; the firm's bonds trade with a yield to maturity of 8 percent; the
current and target debt-equity ratio is 2; if the firm were financed entirely with equity, the
required return would be 10 percent.

Using the weighted average cost of capital methodology, what is the NPV?
An American Hedge Fund is considering a one-year investment in an Italian government bond
with a one-year maturity and a euro-denominated rate of return of i€ = 5%. The bond costs
€1,000 today and will return €1,050 at the end of one year without risk. The current exchange
rate is €1.00 = $1.50. U.S. dollar-denominated government bonds currently have a yield to
maturity of 4 percent. Suppose that the European Central Bank is considering either tightening or
loosening its monetary policy. It is widely believed that in one year there are only two
possibilities:

S1 ($/€) = €1.80 per €

S1 ($/€) = €1.40 per €

Following revaluation, the exchange rate is expected to remain steady for at least another year.

The hedge fund manager notices the optionality in starting this project today. He asks you to
comment and outline your valuation strategy.
1) Show the valuation of this project as a risk-free bond, with the face value of $1,470 plus an at-
the-money call option on 1,400 Euro with a strike price of $1.50/Euro.
2) What is the decision based on the calculated NPV based on 1)?
3) If the option to delay this project for one more year is also available, what is better between
using call option and delaying the project for 1 year?