Question

You have come across a project which has an initial investment of INR 5 crores. The EBIT expected from this project is INR 1 crore in perpetuity, a more stable project with more predictability in the cash flows. Project risk is similar to the business risk of the firm’s core operations. The opportunity cost of capital to the firm if it was an all equity financed firm is 14.5%. The tax rate is 30%. Would you choose this project ? Now you have been told that the initial investment can be financed for a period of 4 years with a INR 5 crores debt (principal amount) at a rate of 9%. The principal amount of the debt will be paid back in 5 equal installments at the end of each year for the next 5 years. Will you change your decision about the project now ?

Answer 1

Initial Investment = 5 crores

EBIT in perpetuity = 1 crore

Tax Rate = 30%

Cash flow= 1* 0.7= 0.7 crore

Cost of Capital = 14.5%

So present value of cash flows= 0.7/0.145= 4.828 crores

NPV= 4.828- 5 = -0.172

NPV of project is negative, so the project should not be chosen .

Now , if a loan is taken of 5 crores @ 9% with repayment in 5 years, the present value of initial investment will be

YEAR	PRINCIPLE REPAYMENT	INTEREST REPAYMENT	TOTAL REPAYMENT	[email protected]%	PresentValue
1	1	0.45	1.45	0.873	1.26585
2	1	0.36	1.36	0.763	1.03768
3	1	0.27	1.27	0.666	0.84582
4	1	0.18	1.18	0.582	0.68676
5	1	0.09	1.09	0.508	0.55372
				TOTAL	4.38983

Present value of initial investment= 4.38983

Present Value of Cash Flows= 4.828

NPV= 4.828-4.38983= 0.43817

NPV of the project is Positive if loan is taken.

so we can choose this project if loan is taken at the given terms.