1. Consider the following data in connection with financing a project.

Investment = $150 million; Debt : Equity = 80:20; Useful life of the project = 2 years
Interest + principal payment at the end of each year = $69 million
Cash flow after tax at the end of the first year = $75 million
Cash flow after tax at the end of the second year = $110 million;
Tax rate = 35%
Risk-free rate of return = 8%;
Return on the market portfolio = 25%; Beta = 1.5
(a) Determine the cost of debt (assuming that net proceeds = gross proceeds), cost of equity
(using the Capital Asset Pricing Model) and the Weighted Average Cost of Capital
(WACC). Check the economic viability of the project.
(b) Explain the underinvestment problem and verify whether the problem exists in this
project financing situation.
(c) Consider the following break-up of costs and revenues (All figures are in $ million).

Year
1

20
75
15
40
150
150
-150

25
10
35
70
110
180
255
75

200
200
310
110

Capital cost
Land
Plant & M/C
Duties/Taxes
Others
Total
Operating cost
Total cost
Revenue
Cash flow

Now, if (i) the present value of the agricultural outputs from the acquired land during the
useful life of the project is $30 million, (ii) 20% of the landed costs of the plant and m/c
is attributed to import duties, and (iii) the import of the project output would have been
10% cheaper, determine whether the project is socially desirable assuming a social rate of
discount of 12%.

Solution: (a) Cost of debt = 9.8%, Cost of equity = 33.5%, WACC = 11.8%,
NPV@11.8% = 5.09 > 0, so, project is economically viable. (b) FCF 1 = 6, FCF2 =
41, NPV@33.5% = -2.5 < 0, so, underinvestment problem exists. (c) NPV@12%
(Social rate of discount) = -9.43 < 0, so, project is not socially desirable.