Question

MVP, Inc., has produced rodeo supplies for over 20 years. The company currently has a debt–equity ratio of 60 percent and is in the 40 percent tax bracket. The required return on the firm’s levered equity is 16 percent. The company 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 −$18,450,000 1- 5,900,000 2- 9,700,000 3- 9,000,000

The company has arranged a debt issue of $9.9 million to partially finance the expansion. Under the loan, the company would pay interest of 8 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 $3,300,000 per year, completely retiring the issue by the end of the third year. Calculate the APV of the project.

Answer 1

First, we need to find out the unlevered NPV.

To do so, we need to calculate the unlevered cost of equity.

RS=R0+ (B/S)(R0–RB)(1 –tC)

0.16 =R0+ (.60)(R0– .08)(1 – .40)

R0= .1388, or 13.88%.

Now we can find the NPV of an all-equity project,

NPV = PV(Unlevered Cash Flows)

NPV = –$18,450,000 + $5,900,000/ 1.1388 + $9,700,000/1.1388^2+ $9,000,000 / 1.1388^3

NPV = $304,432.88

	Debt outstanding	principal repayment	after tax interest payment
Year 0	9,900,000
Year 1	6,600,000	3,300,000	(1-0.40)(0.08)(9,900,000)
Year 2	3,300,000	3,300,000	(1-0.40)(0.08)(6,600,000)
Year 3	0	3,300,000	(1-0.40)(0.08)(3,300,000)

NPV = $9,900,000 – (1 – .40)(.08)($9,900,000)/1.08–$3,300,000 / 1.08 – (1 – .40)(.08)($6,600,000) / 1.08^2–$3,300,000 / 1.08^2– (1 – .40)(.08)($3,300,000) / 1.08^3–$3,300,000 / 1.08^3

NPV =$ 558,233

then the APV of project is:

APV = NPV(All-equity) + NPV(Financing side effects)

APV = $304,432 + $558,233

APV = $862,665.88