Question

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. Part of this amount will come from debt of $750,000 (held in perpetuity). Currently, Sampa Video, Inc. 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%. Sampa Video, Inc. 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 $ thousand 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 differsolution . i would

There are two answers on Chegg study to this question, I need to know which one is correct. I am running out of time, please and thank you

Answer 1

ADJUSTED PRESENT VALUE(APV)=(Present Value of Cash Flows of Unlevered firm)+ Present Value of Interest Tax Shield

Present Value of Cash Flows of Unlevered firm:

N	Year	1	2	3	4	5
a	Revenue-Cost	180	360	585	840	1125
b	Less:Depreciation	200	225	250	275	300
c=a-b	Before tax operating Income	-20	135	335	565	825
d=c*40%	Taxes	-8	54	134	226	330
e=c-d	After tax operating income	-12	81	201	339	495
f	Add: Depreciation (non cash expense)	200	225	250	275	300
g=e+f	Operating Cash Flow	188	306	451	614	795
h	Less: Delta NCW	0	0	0	0	0
i	Less: Capital Expenditure	300	300	300	300	300
j=g-h-j	Net Cash Inflow	-112	6	151	314	495	SUM
PV=j/(1.158^N)	Present Value of Net Cash inflows	-101.8	4.959	113.4485	214.4662	307.3561	538.4113

Total Present Value of Cash inflows using unlevered equity=538.411

Intial Cash Outflow=800

Net Present Value of Unlevered Firm=538.411-800=-261.589

PRESENT VALUE OF INTEREST TAX SHIELD:

Annual interest expense=750 *6.8%=51

Annual Interest tax shield =51*40%=20.4

Number of Years of Tax saving=5

Discount rate =cost of debt=6.8%

Present Value Factor=PWF=(P/A,i,N)=(((1+i)^N)-1)/(i*((1+i)^N))

i=discount rate =6.8%=0.068

N=Number of years=5

PWF=(P/A,6.8%,5)=(((1+0.068)^5)-1)/(0.068*((1+0.068)^5))=4.1225

Present Value of Interest Tax Shield=20.4*4.1225=84.094

ADJUSTED PRESENT VALUE(APV)= -261.589+84.094=-177.495

Adjusted Present Value is NEGATIVE; Project should not be accepted

4.In case of highly leveraged transaction like this, because in WACC method the cost of capital decreases significantly with high leverage thus resulting in acceptance of projects which should be rejected. In APV method, the interest tax shield is calculated separately , thus reflecting the Adjusted Present Value more accurately and in a easily understandable manner .