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Suppose management of Company ABC is evaluating a project which has an initial outlay of $10 million and an expected cash flow of $3 million per year for each of the next five years. Assume that the company"s (i) marginal tax rate is 40%, (ii) debt-to-equity ratio equal to 1, and (iii) after-tax cost of debt of 4% and a cost of equity of 6%. The cost of equity is estimated using the Capital Asset Pricing Model assuming a beta of 1.2, a risk-free interest rate of 3%, and an expected return on the market of 7%.
a. What is the net present value for this project?
b. What is the adjusted present value for this project if the effect of financial distress is ignored?
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Explain the two distinct sets of project options dealt with in every evaluation. In your description, identify an example of each set.
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