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Consider the following case study and answer the questions. Microsoft is evaluating a potential investment in a new datacenter facility located in...
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Question

Consider the following case study and answer the questions.

  • Microsoft is evaluating a potential investment in a new datacenter facility located in Europe. The initial capital investment in this facility is $10 million with an expected useful life of 5 years.
  • The datacenter is to be depreciated to a book value of $0 over the 5 years and it is expected that it can be sold for $2 million at the end of the project.
  • Microsoft has already commissioned a consulting firm in order to perform a technical due diligence of the facility. The services fee paid amount to $500,000.
  • The gross revenue that Microsoft is planning to generate with the new facility will be $2.8 million per year for the 5 years (starting at the end of year 1).
  • The annual variable cost for the datacenter will be 25% of the gross revenues for every year.
  • The project requires $500,000 of working capital immediately but it will not require any other working capital investments during its life. The working capital will be recovered in the last year of the project.
  • The corporate tax rate is 30% and Microsoft has a weighted average cost of capital of 15%.
  • Microsoft is planning to finance this project using a higher proportion of debt than the one used to finance the company as a whole.


You are told in the question that Microsoft will be financing the project using a higher proportion of debt than the one used to finance the company as a whole. What risk is Microsoft incurring by using the company's WACC as a discount rate? What would happen to the WACC and NPV of the project in the case Microsoft would be using the appropriate discount rate? Under what conditions the WACC can be used as a discount rate for the cash flows of a specific project?  

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Subject: Business, Finance

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