Question

Given the information:

Cash inflows: $500,000 per year for indefinite year;

Cash costs: 72% of sales

Initial investment: $475,000

Tax rate: 34%

Unlevered required rate of return = 20%

It is assumed that the firm finances 25% of the investment by debt (interest rate of 10%) and the remaining by equity.

Required:

Calculate the value of project using:

(a) APV;

(b) FTE; and

(c) WACC approaches.

Answer 1

The value of project using
1. APV method
cash inflows - $ 500,000 per year for indefinite years
cash expenses = 72 % of inflows
Net inflows = 28 % of 5,00,000
	140000
Net after tax inflows		: = 1,40,000 x (1-.34 )
		92400
Debt = 25 % of 4,75,000
118750
Pearson’s tax rate is 34%, so they have an interest tax shield worth ?C rB B = 0.34 ×0.1 ×$118750 = $4037.5 each year.
The net present value of the project under leverage is:
NPV at 20 % = 92400/.2 + 4037.5/0.1
	27375
2. FTE method
Since the firm is using $118750 of debt, the equity holders only have to come up with $356250 of the initial $475,000. Thus, CF0 = –$ 356250
• Each period, the equity holders must pay interest expense. The after-tax cost of the interest is (1 – ?C)× rB × B = (1 – 0.34) ×0.1 ×$118750 = $ 7837.5
Cash flow after tax cost of interest = (92400-7838)/.2 + 4037.5/.1
463185	PV
which is less than 475,000 initial investment
3. WACC approach
D/ E RATIO = 25/75 = 1/3			B/ S = 1/3
r wacc	: = 1/3*.10 + 2/3*.2
	0.166667	16.67
NPV	79289.14