Question

Zoso is a rental car company that is trying to determine whether to add 25 cars to its fleet. The company fully depreciates all its rental cars over six years using the straight-line method. The new cars are expected to generate $160,000 per year in earnings before taxes and depreciation for six years. The company is entirely financed by equity and has a 40 percent tax rate. The required return on the company’s unlevered equity is 11 percent, and the new fleet will not change the risk of the company.

a. What is the maximum price that the company should be willing to pay for the new fleet of cars if it remains an all-equity company? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

Suppose the company can purchase the fleet of cars for $465,000. Additionally, assume the company can issue $375,000 of six-year, 7 percent debt to finance the project. All principal will be repaid in one balloon payment at the end of the sixth year. What is the adjusted present value (APV) of the project? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

Answer 1

Present Value Factor (PVF) table for a discount rate of 11% = 1/(1+11%)ⁿ

Year	PVF
1	0.9009
2	0.8116
3	0.7312
4	0.6587
5	0.5935
6	0.5346
	4.2305

Earnings per year (A)	160,000.00
Tax@40% (B) = 160,000 x 40%	64,000.00
AfterTaxEarning A (-) B	96,000.00
Discounted Earnings for 6 years	406,131.63	(96,000 x 4.2305)

Therefore the NPV will be Zero if the company purchases the car at 406,131.63. If the price is more than 406,131.63 then the NPV will become negative, hence company should not pay more than 406,131.63.

If the company issues Debt partially:

Calculation of Weighted Average Cost of Capital

Component	Value	Proportion	Cost	Tax	WACC
Equity	90,000	19.35%	11%	0%	2.13%	(19.35% x 11% x (1-0%)
Debt	375,000	80.65%	7%	40%	3.39%	(80.65% x 7% x (1-40%)
	465,000	100.00%			5.52%

Present Value Factor (PVF) table for a discount rate of 11% = 1/(1+5.52%)ⁿ

Year	PVF
1	0.9477
2	0.8981
3	0.8511
4	0.8066
5	0.7644
6	0.7244
	4.9924

Particulars	Period	CashFlow	PVF	DCF
Earning (A)	Year 1 to 6	160,000.00	4.9924	798,778.39
Interest (B) = (375,000 x 7%)	Year 1 to 6	-26,250.00	4.9924	-131,049.58
Tax (C) = (A+B) x 40%	Year 1 to 6	-53,500.00	4.9924	-267,091.52
Net Income (D) = A+B+C	Year 1 to 6	80,250.00	4.9924	400,637.29
Repayment of Debt (E)	Year 6	-375,000.00	0.7244	-271,658.05
Initial Investment Equity (F1)	Year 0	-90,000.00	1.0000	-90,000.00
Debt Fund Received (F2)	Year 0	375,000.00	1.0000	375,000.00
Adjusted NPV = D+E+F1+F2				413,979.24