Question

Gemini Inc. an all equity firm is an investment of 1.66 million that will be depreciated according to the straight-line method over its four year life. The project is expected to generate earnings before taxes and depreciation of 600,000 per year for four years. The investment will not change risk level of the firm. The company can obtain a four year, 8.1 percent loan to finance the project from a local bank. All principal will be repaid in one balloon payment at the end of the fourth year. The bank will charge the firm 50,000 in flotation fees which will be amortized over the four year life of the loan. If the company financed the project entirely with equity, the firms cost of capital would be 14 percent. The corporate tax rate is 35 percent.

Using the adjusted value method, calculate the APV of the project. Round to two decimal places

Answer 1

Answer :

Step 1: Calculate NPV (All Equity)

The value of NPV (all equity) is arrived as below:

NPV (All Equity) = -Initial Investment + Annual Earnings*(1-Tax Rate)*PVIFA(Rate,Years) + Depreciation*Tax Rate*PVIFA(Rate,Years)

Substituting values in the above formula, we get,

NPV (All Equity) = -1,660,000 + 600,000*(1-35%)*PVIFA(14%,4) + 1,660,000/4*(35%)*PVIFA(8.1%,4)

NPV (All Equity) = -1,660,000 + 390,000*2.9137 + 145,250*3.3048 = -$43,634.8 [actual present factor value have been taken. Present value factors have shown been upto 4 decimal places only for representation purposes]

Step 2: Calculate NPV (Financing Side Effects)

The value of NPV (financing side effects) is calculated as follows:

NPV (Financing Side Effects) = (Loan - Flotation Costs) - Annual Interest Payment*Interest Rate on Loan*(1-Tax Rate)*PVIFA(Rate,Years) - Loan Amount/(1+Interest Rate)^Years + Tax Rate*Annual Flotation Cost*PVIFA(Rate,Years)

Substituting values in the above formula, we get,

NPV (Financing Side Effects) = (1,660,000 - 50,000) - 1,660,000*8.1%*(1-35%)*PVIFA(8.1%,4) - 1,660,000/(1+8.1%)^4 + 0.35*50,000/4*PVIFA(8.1%,4)

NPV (Financing Side Effects) = 1,610,000 - 84,399*3.3048 - 1,215,640.925 + 4,375*3.3048 = $129,895.76 [actual present factor value have been taken. Present value factors have shown been upto 4 decimal places only for representation purposes].

Step 3: Calculate APV

The adjusted present value is determined as below:

APV = NPV (All Equity) + NPV (Financing Side Effects) = -$43,634.8 + $129,895.76 = $86,260.96.