Question

Bil‐A‐Bong Enterprises is considering taking on a new project. The project itself requires a net investment of $5 million and is expected to generate pre‐tax earnings of $1 million per year growing at 2% in perpetuity. The object of the proposed project is to make snowboards. Swoosh, the dominant player in the industry, is a single product company, making snowboards exclusively. Swoosh is all‐equity financed. It has a beta of 0.75. The risk‐free rate is 10% and the market risk premium is 10%. Assume that Bil‐A‐Bong can borrow at the risk‐free rate, and that both firms face a corporate tax rate of 34%.

(a) What is the NPV of the project if it is all equity financed?

(b) What is the NPV of the project if Bil‐A‐Bong issues $4 million annual coupon debt due in 5 years to make the investment?

One of the interesting features about this venture is the planned marketing strategy for this product. These snowboards will be ‘family’ oriented and will be advertised and marketed as such. The idea came out of the division of Bil‐A‐Bong that owns Boring Downhill Ski Mountain in Whistler, BC. Boring would like the idea to work so are willing to subsidize the enterprise by offering the snowboard division a $1 million interest‐free loan for 5 years to finance the investment.

Calculate the NPV of the project if the remaining investment is:

(c) equity financed.

(d) debt financed.

Answer 1

Answer to part 1
It is assuming the earning from the investment is for indefinite number of years for this part.
formula for the NPV = Present value of Cash inflow - present value of cash outflow
Let us calculate present value of cash inflow

formula for present value of cash inflow
PV = cash inflow / (Ke-g)
where, Ke = cost of equity
g= growth rate.

we have, g = 2%
Ke can be calculated through CAPM model
Ke = Rf+B ( risk premium )
Ke = 10+0.75*10
Ke = 17.50
Therefor,
PV of cash inflow = 1000000/(17.5-2)
PV of cash inflow = 6451613

Hence,
NPV = Present value of Cash inflow - present value of cash outflow
NPV = 6451613 - 5000000
NPV = 1451613

Answer to part 2

We have, equity = 1000000 and debt = 4000000

Calculation of Present value of interest expenses for 5 years :-

Interest expenses net of tax = 10 ( 1 - 0.34 ) * 4000000 = 264000

present value of 264000 for 5 years @ 6.6% = 264000*4.143

( annuity value of discounting factor of 6.6% for 5 years is 4.143 )

PV of interest expenses = 1093752

NPV = PV of cash inflows - PV of cash outflows

NPV = (6451613 - 1093752) - 5000000

NPV = 5357861 - 5000000

NPV = 357861

Answer to part 3

Being 1000000 is interest free and 400000 is arranged through equity finance. It means company will not have any interest cost to bear.

Hence,

NPV = Present value of Cash inflow - present value of cash outflow
NPV = 6451613 - 5000000
NPV = 1451613

Answer to 4

Being 1000000 is interest free and 400000 is arranged through debt with rate of interest 10%.

We have, interest free loan = 1000000 and debt = 4000000

Calculation of Present value of interest expenses for 5 years over 4000000:-

Interest expenses net of tax = 10 ( 1 - 0.34 ) * 4000000 = 264000

present value of 264000 for 5 years @ 6.6% = 264000*4.143

( annuity value of discounting factor of 6.6% for 5 years is 4.143 )

PV of interest expenses = 1093752

NPV = PV of cash inflows - PV of cash outflows

NPV = (6451613 - 1093752) - 5000000

NPV = 5357861 - 5000000

NPV = 357861