Question

Consider a project to produce solar water heaters. It requires a $10 million investment and offers a level after-tax cash flow of $1.56 million per year for 10 years. The opportunity cost of capital is 9.25%, which reflects the project's business risk.

Suppose the project is financed with $4 million of debt and $6 million of equity. The interest rate is 5.25% and the marginal tax rate is 21%. An equal amount of the debt will be repaid in each year of the project's life.

a. Calculate APV. (Enter your answer in dollars, not millions of dollars. Do not round intermediate calculations. Round your answer to the nearest whole number.)

b. If the firm incurs issue costs of $730,000 to raise the $6 million of required equity, what will be the APV? (Enter your answer in dollars, not millions of dollars. Do not round intermediate calculations. Round your answer to the nearest whole number. Negative amount should be indicated by a minus sign.)

Answer 1

a]

APV = NPV + present value of interest tax shield

NPV = -$10 million + ($1.56 million * PVAF(9.25%, 12)) where PVAF is the present value annuity factor for $1

NPV = -$10 million + ($1.56 million * 7.0714) = -$1,031,414

Interest paid each year, the interest tax shield, and the present value interest tax shield are calculated as below :

present value of interest tax shield = $174,129

APV =  -$1,031,414 + $174,129 = -$857,285

b]

APV = NPV + present value of interest tax shield - present value of cost of equity financing

APV =   -$857,285 - $730,000 = -$1,587,285