COST OF CAPITAL, NET PRESENT VALUE
Leakam Company's product engineering department has developed a new product that has a three-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 issu- ing $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 three years, with the principal being repaid at the end of year 3. The stock issue carries with it an ex- pectation of a 17.5 percent return, expressed in the form of dividends at the end of each year ($7,000 in dividends is expected for each of the next three 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 three years.
Required:
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. 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.