Question

Gemini, Inc., an all-equity firm, is considering a $1.7 million investment that will be depreciated according to the straight-line method over its four-year life. The project is expected to generate earnings before taxes and depreciation of $595,000 per year for four years. The investment will not change the risk level of the firm. The company can obtain a four-year, 9.5 percent loan to finance the project from a local bank. They will receive the total amount needed for investment ($1.7 million at time 0 and all principal will be repaid in one balloon payment at the end of the fourth year (similar to a bond). Every year the company would need to pay interest (@9.5%). If the company finances the project entirely with equity, the firm’s cost of capital would be 13 percent. The corporate tax rate is 30 percent. Calculate the cash flows and NPV for the two cases: a) If the company finances the project entirely with equity, and b) if the company finances the project entirely with the bank loan. Are the answers different? If so, why? Should the project be undertaken? (Hint: In the first case you need to discount your cash flows at 13% and in the second case with 9.5% when you calculate NPV).

Answer 1

a) the company finances the project entirely with equity:

The yearly cash flows (after tax) are $544,000 and net present value is negative $81,888.

b) the company finances the project entirely with the bank loan:

The yearly cash flows (after tax) are $430,950 and net present value is positive $198,495.

The yearly cash flows and Net present vallue are different for both the options due to the following:

1. When the company finances the project with bank loan, the company has to pay annual interest which reduces its annual cash-flows compared to financing fully with equity

2. The cost of capital is higher for equity at 13% as against 9.5% for loan. Higher cost of capital results in lower present value and thus present value of equity option is lower.

3. When the company finances the project with equity, it has to completely pay the investment cost of $1.7 million immediately. However, if the company takes bank loan, it has to only pay the $1.7 million at the end of 4th year the present value of which is significantly lesser than the equity scenario. Thus, the present value of initial investment for bank loan option is significantly lesser resulting in positive NPV for bank loan option.

The Net Present value of the project when it is finances entirely with bank loan is positive at $198,495. Hence the company can choose the project and fund it entirely with bank loan.