Question

NeoDiagnostic is an all-equity firm with 10,000 shares on the issue currently selling for $25.36 each. The CAPM beta coefficient for NeoDiagnostic's (currently unlevered) equity is 1.6, while the riskless interest rate is 1.25% and the market risk premium is 5.75%. After share trading for the day ceases, NeoDiagnostic announces a new project to manufacture a "breakthrough product" arising from its just-completed R&D program. The project will require it to invest $1.25 million. The investment can be depreciated on a straight-line basis over 10 years, with the first allowance available one year from today. NeoDiagnostic uses the riskless interest rate to discount the associated depreciation tax shield.
The project is expected to produce before-tax operating cash flow equal to $237,000 at the end of the first year, growing at 4% annually for each of the following 3 years, then remaining constant for the following 6 years, at which point the project ends. The corporate tax rate is 21%. When announcing the project, NeoDiagnostic also announced that it intends to borrow $750,000 at an interest rate of 6% per annum to partially finance the project. Remaining funds needed for the investment will be raised through a new equity issue. The debt will be retired in full at the conclusion of the project in 10 years from now. Assume that the corporate tax effect of debt approximates the overall effect of debt on firm market value. NeoDiagnostic believes that the new project will not alter investor's perceptions of the fundamental risks for the company's business.
(a) Use the APV approach to levered valuation to calculate the NPV of this investment project.

(b) What should happen to the price of the company's stock upon announcement of the investment project and associated financing mechanism?

(c) How many shares would have to be floated to finance the investment?

(d) Write down the market value balance sheet immediately before the project and associated financing mechanism is announced.

Answer 1

	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9	Year 10	Remark
Investment	(1,250,000)
depreciation Tax Shied	(26,250)	(26,250)	(26,250)	(26,250)	(26,250)	(26,250)	(26,250)	(26,250)	(26,250)	(26,250)	" 1.25 Mn / 10 years x Tax"
Debt Raised / repaid	750,000	-	-	-	-	-	-	-	-	(750,000)
Interest	(45,000)	(45,000)	(45,000)	(45,000)	(45,000)	(45,000)	(45,000)	(45,000)	(45,000)	(45,000)
Cashflow (without Tax)	237,000	246,480	256,339	266,593	266,593	266,593	266,593	266,593	266,593	266,593
		"Growth of 4%"	"Growth of 4%"	"Growth of 4%"	"Same as LY"	"Same as LY"	"Same as LY"	"Same as LY"	"Same as LY"	"Same as LY"
Cashflow after Interest	192,000	201,480	211,339	221,593	221,593	221,593	221,593	221,593	221,593	221,593
depreciation	(125,000)	(125,000)	(125,000)	(125,000)	(125,000)	(125,000)	(125,000)	(125,000)	(125,000)	(125,000)
Profit before tax	67,000	76,480	86,339	96,593	96,593	96,593	96,593	96,593	96,593	96,593
Tax	14,070	16,061	18,131	20,284	20,284	20,284	20,284	20,284	20,284	20,284
PAT	52,930	60,419	68,208	76,308	76,308	76,308	76,308	76,308	76,308	76,308
a.	The Adjusted Present Value (APV) is the net present value (NPV) approach where cost of equity is used for discounting the cashflow with taking any impact of Debt funding. Then, impact of Debt is saperatly added to the project with tax benfit.
Cashflow to equity	237,000	246,480	256,339	266,593	266,593	266,593	266,593	266,593	266,593	266,593	PBT + Depreciation + Interest
Investment	(1,250,000)
Cost of Equity	10.5%
NPV	$1,137,136
Debt Raised / repaid	750,000	-	-	-	-	-	-	-	-	(750,000)
Interest	(45,000)	(45,000)	(45,000)	(45,000)	(45,000)	(45,000)	(45,000)	(45,000)	(45,000)	(45,000)
Tax	(14,070)	(16,061)	(18,131)	(20,284)	(20,284)	(20,284)	(20,284)	(20,284)	(20,284)	(20,284)
depreciation Tax Shied	(26,250)	(26,250)	(26,250)	(26,250)	(26,250)	(26,250)	(26,250)	(26,250)	(26,250)	(26,250)
Total Benefit of tax and debt	664,680	(87,311)	(89,381)	(91,534)	(91,534)	(91,534)	(91,534)	(91,534)	(91,534)	(841,534)
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