Question

In: Finance

A small video chain is deciding whether to engage in a new line of delivery business,...

A small video chain is deciding whether to engage in a new line of delivery business, which implies setting up a page where customers could choose movies based on available in-store inventory and pick a time for delivery. The purpose of this analysis is to obtain an estimate of the net present value of this project, which requires an upfront investment of $800,000. Half of this amount will come from a debt of $750,000 (held in perpetuity). Currently, the firm. is unlevered. Assume that the cost of debt is 6.8%, the corporate tax is 40% and the return required by equity investors in the all-equity firm is 15.8%. The firm is planning to run the new line of delivery only for the next 5 years. The following financial information is available regarding the expected cash flows of the new line of delivery (in $ thousands):

Projected

(t=1)

Projected

(t=2)

Projected

(t=3)

Projected

(t=4)

Projected

(t=5)

delta (NWC)

0

0

0

0

0

Capital Expenditures

300

300

300

300

300

Depreciation

200

225

250

275

300

Revenue -Costs

180

360

585

840

1,125

Questions:

1. Calculate the unlevered present value

2. Calculate the present value of the expected interest tax shields

3. Calculate the APV.

4. Why is APV a preferable method to WACC in this situation? How do their assumptions differ?

Solutions

Expert Solution

4. Why is APV a preferable method ?

The value of a project financed with debt may be higher than that of an all equity-financed one since the cost of capital often decreases with leverage, turning some negative NPV projects into positive ones. Thus, under the NPV rule, a project may be rejected if it’s financed with only equity, but may be accepted if it’s financed with some debt. Moreover, the APV approach takes into consideration the benefits of raising debts (e.g. interest tax shield), which NPV does not do. As such, APV analysis is widely preferred in highly leveraged transactions.

The WACC approach assumes that debt is a constant proportion of company value instead of the fixed amount of debt assumed by M&M.


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