Question

A company is considering purchasing a special machine to expand one of its production lines. The machine costs $1,000,000 and has an estimated service life of 3-years. Annual after-tax revenues are expected to be $430,000 and the salvage value of the machine at the end of the third year, could be $40,000.

To maximize its ROI, the company is considering borrowing the full purchase amount from a local bank at 12% annual interest, instead of funding the purchase from its retained earnings (equity financing). The company believes it can arrange to pay the bank only interest expenses over the project life and postpone the repayment of the principal of the borrowed amount until the end of the third year. MARR is 15%, and the corporate tax rate t = 45%. (ignore depreciation)

Can you help the company calculate the amount of gain (or loss) in the project NPV, due to debt financing of the project?

NOTE: After tax revenues or expenses are calculated by multiplying before tax values by (1-t)

INSTRUCTIONS

1. Use Excel to calculate the NPV of the project for the equity financing option.
2. Calculate the NPV of the project for the debt financing option.
3. Calculate the gain (or loss) in the project NPV due to debt financing instead of equity financing.

Answer 1

Answer :

1) NPV of the Project under Equity Finance Method = $8,087

2) NPV of the project under debt Finance Method = $1,99,879

3) Gain due to debt financing instead of Equity Financing = $1,99,879 - $8,087 = $1,91,792.

we have to use MARR @15% for Discounting the future cash flows as it is rate applicable for the company.

Remember : Whenever the Post Tax Interest rate is lower than the MARR, Debt financing is always beneficial than equity financing. It is called trading on equity. Here MARR is 15% & Post Tax debt cost is 12%(1-45%) = 6.6%

Note

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