Question

Suppose you have a project with a projected annual cash flow before interest and taxes of $6 million, indefinitely. The initial investment of $18 million will be financed with 60% equity and 40% debt. Your tax rate is 34%, your cost of capital if you were an all-equity firm is 24%, and your usual borrowing rate is 10%. Your project has been reviewed by your local city government and has been selected to receive municipal funding at a rate of 8%. There will, however, be a flotation cost to this debt of $500,000, which must be expensed immediately and will be paid from the gross proceeds of your debt. Using APV, determine whether to approve this project or not.

Answer 1

1. In Adjusted Price Value (APV) method, we first estimate the present value of the project by discounting it at the rate of cost of equity assuming it to be without any leverage

2. In the next step we calculate the present value of expected tax benefit from the given level of debt financing in this case (40%)

3. The NPV of the tax effect is than added to the base NPV (which we gets from step 1).

Project details:

Investment size: $18,000,000

Cash flow before interest and taxes: $6,000,000

Financed by: 60% equity and 40% debt

Tax rate: 34%

Cost of equity: 24%

Cost of debt: 10%

Interest rate: 8%

Floatation cost to debt: $5,000,000

Step 1: Initial investment + (post tax projected annual cash flow ) and discount this by taking cost of equity as the discount rate

=-18000000 + (6000000(1-34%))/24%

= -1,500,000

Step 2: Tax saving from debt (which is 40% of intial investment and 8% interest paid thereon) less floatation cost of $500,000 and discount this by taking cost of debt as the discount rate

= ((34%*18,000,000*40%*8%)/10%)-500,000

=1,958,400-500,000 = 1,458,400

Step 3: Add the above two NPV

= -1,500,000+1,458,400

=-41600

Now, since the value is negative we will reject the project.