Question

Roger has a levered cost of equity of 0.17. He is thinking of investing in a project with upfront costs of $8 million, which pays $2 million per year for the next 8 years. He is going to borrow $4 million to offset the startup costs at a rate of 0.05. His tax rate is 0.4. He will repay this loan at the end of the project. What is the NPV of this project, using the FTE method?

Answer 1

> Formula & Concept

The Flow to Equity (FTE) method calculates the firm’s levered cash flow to equity (LCFE) using the following formula:

• LCFE = Unlevered Cash Flow – Interest × (1 – tax rate),
• LCFE is then discounted with return on equity to get the value of equity.
• Total value is VL = E + D.

> Calculation

LCFE = 2000000 - [ 4000000 * 0.05 ] * ( 1 - 0.40 )

         = 2000000 - 120000

         = $ 18,80,000

Equity Value = 1880000 * PVAF(17%, 8)

                   = 1880000 * [ 1/1.17 + 1/1.17² +.....+ 1/1.17⁸ ]

                  = 1880000 * 4.2072

                   = $ 79,09,536

Firm Value = Equity + Debt

                = 79,09,536 + 40,00,000

= $ 1,19,09,536 Answer

Hope you understand the solution.