Question

Knotts, Inc., an all-equity firm, is considering an investment of $1.82 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 $608,000 per year for four years. The investment will not change the risk level of the firm. The company can obtain a four-year, 8.8 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 $58,000 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 firm’s cost of capital would be 12 percent. The corporate tax rate is 22 percent.

   

Using the adjusted present value method, calculate the APV of the project. (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89)

Answer 1

Adjusted Present Value=Base Case NPV+Tax Sheild on interest-Floatation Cost

Base Case NPV is the NPV assuming there is no debt in the capital structure means only equity is there.

Calculation of CFAT:

Particular	Amount
Profit before Depreciation & Tax	608000
(-)Depreciation	455000
Profit After Depreciation	153000
(-)Tax@22%	33660
Profit after tax	119340
(+)Depreciation	455000
CFAT	574340

Calculation of Base Case NPV:

Cost of equity(ke) shall be used for discounting CFAT.

PV factor=1/(1+ke)^ⁿ

Year	Cash Flow	PV Factor	Present Value
0	-1820000	1	-1820000
1	574340	0.892857	512803.5714
2	574340	0.797194	457860.3316
3	574340	0.71178	408803.8675
4	574340	0.635518	365003.4532
Net Present Value			-75528.77626

Hence Base Case NPV is -75528.77626

Calculation of Tax Shield on interest:

Interest=1820000*.088

=160160 Per anum.

Year	Interest	Tax Saved	PV Factor	Present Value
1	160160	35235.2	0.919118	32385.29412
2	160160	35235.2	0.844777	29765.89533
3	160160	35235.2	0.77645	27358.35968
4	160160	35235.2	0.713649	25145.55117
Present Value of Tax Shield				114655.1003

Note:

Tax Saved =Interest*tax rate

PV factor=1/(1+.088)^{^n}

Hence

Adjusted Present Value=Base Case NPV+Tax Sheild on interest-Floatation Cost

=-75528.77626+114655.1003-58000

=-18873.676

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