Question

MVP, Inc., has produced rodeo supplies for over 20 years. The company currently has a debt–equity ratio of 50 percent and is in the 35 percent tax bracket. The required return on the firm’s levered equity is 15 percent. MVP is planning to expand its production capacity. The equipment to be purchased is expected to generate the following unlevered cash flows:

  

Year	Cash Flow
0	?$18,200,000
1	5,720,000
2	9,520,000
3	8,820,000

  

The company has arranged a $9.36 million debt issue to partially finance the expansion. Under the loan, the company would pay interest of 9 percent at the end of each year on the outstanding balance at the beginning of the year. The company would also make year-end principal payments of $3,120,000 per year, completely retiring the issue by the end of the third year.

  

Calculate the APV of the project. (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

  

APV

$

Answer 1

Calculation of Adjusted Present VAlue (APV):

Let us first calculate the discount rate:

Cost of Equity(R_e) = R_c + [D/E * (1-t) * (R_e - R_d)]

Where Rc = Cost of Capital for All equity firm (?)

DE = Debt/Equity (50%)

t = Tax rate(35%)

Rd = Cost of Debt (9%)

Replacing with values from the question.

15% = Rc + [50% * (1-35%)*(Rc-9%)

0.15 = Rc + [0.50 * 0.65* (Rc-0.09)

0.15 = Rc +0.325Rc - 0.02925

Rc = (0.15+0.02925)/1.325 = 0.135283 or 13.53%

Calculation of Present Value (discount rate 13.53%)

Present Value
Year	Cash Flow	PV of cash flow
0	-18,200,000	-18,200,000
1	5,720,000	5038315.864
2	9,520,000	7386108.324
3	8,820,000	6027492.402
NPV		251,917

Interest = Debt Value * Coupon Rate

NPV = [Debt Value - PV of debt repayment - PV of future Interest payments]

NPV = [9,360,000 - ((9,360,000*0.09*0.65)/1.09) - (3,120,000/1.09) - (((9,360,000-3,120,000)*0.09*0.65)/1.09^2)-(3,120,000/1.09^2) - (((9,360,000-3,120,000-3,120,000)*0.09*0.65)/0.09^3) - (3,120,000/1.09^3)]

NPV = -$511826.225

Now APV = $251,917+(-$511826.225) = -$259,909.23

Adjusted Present Value of the Project is negative. Hence NPV rule says that if it comes negative, reject the project.