Question Number 01   Why is NPV considered a superior method of evaluating the cash flows from a project? Suppose the NPV for a project’s cash flows is computed to be $2,500

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Question Number 01

 

1. Why is NPV considered a superior method of evaluating the cash flows from a project? Suppose the NPV for a project’s cash flows is computed to be $2,500. What does this number represent with respect to the firm’s shareholders?
2. What is the cost of capital? What role does it play in long-term investment decisions?
3. After careful analysis, Dexter Brothers has determined that its optimal capital structure is composed of the sources and target market value weights shown in the following table.

Source of capital	Target market value weight
Long term debt	30%
Preferred Stock	15%
Equity	55%

The cost of debt is estimated to be 7.2%; the cost of preferred stock is estimated to be 13.5%; the cost of retained earnings is estimated to be 16.0%; and the cost of new common stock is estimated to be 18.0%. All of these are after-tax rates. The company’s debt represents 25%, the preferred stock represents 10%, and the common stock equity represents 65% of total capital on the basis of the market values of the three components. The company expects to have a significant amount of retained earnings available and does not expect to sell any new common stock. Calculate the weighted average cost of capital on the basis of historical market value weights. Also calculate the weighted average cost of capital on the basis of target market value weights. Consider tax rate to be 40%.