Question

Gemini, Inc., an all-equity firm, is considering a $1.7 million investment 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 $595,000 per year for four years. The investment will not change the risk level of the firm. The company can obtain a four-year, 9.5 percent loan to finance the project from a local bank. They will receive the total amount needed for investment ($1.7 million at time 0) and all principal will be repaid in one balloon payment at the end of the fourth year (similar to a bond). Every year the company would need to pay interest (@9.5%). If the company finances the project entirely with equity, the firm’s cost of capital would be 13 percent. The corporate tax rate is 30 percent. Calculate the cash flows and NPV for the two cases: a) If the company finances the project entirely with equity, and b) if the company finances the project entirely with the bank loan. Are the answers different? If so, why? Should the project be undertaken? (Hint: In the first case you need to discount your cash flows at 13% and in the second case with 9.5% when you calculate NPV).

	Case A		Case B
	All equity financing		All debt financing
Earnings
Depreciation
Interest
EBT
Taxes
Net Income
Add back Depreciation
Annual After-tax Cash Flow
Time	Cash Flow		Cash Flow	<--- Note that these should be the cash flows to the company (what they pay and what they receive)
0
1
2
3
4
Discount rate	13%		9.50%
NPV
Decision (accept or reject)	reject		Accept

Answer 1

Particulars	Case A(Equity)	Case B(Debt)
Earnings	$                      595,000.00	$       595,000.00
Depreciation	$                      425,000.00	$       425,000.00
Interest	$                                       -	$       161,500.00
EBT	$                      170,000.00	$            8,500.00
Taxes	$                        51,000.00	$            2,550.00
Net Income	$                      119,000.00	$            5,950.00
Depreciation Added Back	$                      425,000.00	$       425,000.00
Annual After Tax Cash Flow	$                      544,000.00	$       430,950.00
Case A(Equity)
Time	Discount Factor @ 13%	Cashflows	Discounted Cashflows
0	1.00	$ (1,700,000.00)	$               (1,700,000.00)
1	0.88	$       544,000.00	$                     481,415.93
2	0.78	$       544,000.00	$                     426,031.80
3	0.69	$       544,000.00	$                     377,019.29
4	0.61	$       544,000.00	$                     333,645.39
		NPV	$                     (81,887.60)
		Decision	Reject
Case B(Debt)
Time	Discount Factor @ 9.5%	Cashflows	Discounted Cashflows
0	1.00	$                         -	$                                      -
1	0.91	$       430,950.00	$                     393,561.64
2	0.83	$       430,950.00	$                     359,417.03
3	0.76	$       430,950.00	$                     328,234.73
4	0.70	$ (1,269,050.00)	$                  (882,718.56)
		NPV	$                     198,494.84
		Decision	Accept