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

Solution:

The adjusted present value of a project equals the net present value of the project under all-equity financing and the net present value of any financing side effects.

APV = NPV (All-equity) + NPV (Financing side effects)

First, we calculate the NPV (All-equity)

NPV (All-equity) =-Initial Investment + PV [(1 - tax rate) (Earnings before taxes and depreciation)] + PV (Depreciation tax shield)

NPV (All-equity) = -$1,820,000 + (1 - 0.22) ($608,000) (PVIFA @ 12%, 4) + ($1,820,000/4) (0.22) (PVIFA @ 12%, 4)

NPV (All-equity) = -$1,820,000 + 1,440,433 + 304,038.7

NPV (All-equity) = -$75528.80

Now, we find NPV (Financing side effects)

NPV (financing side effects) = Proceeds, net of flotation costs - After-tax PV (Interest payments) - PV (Principal payments) + PV(Flotation cost tax shield)

NPV (financing side effects) = ($1,820,000 - $58,000/4) - (1 - 0.22) (0.088) ($1,820,000)(PVIFA @ 8.80%, 4) - [$1,820,000/1.088^4] + (0.22) ($58,000/4)(PVIFA @ 8.80%, 4)

NPV (financing side effects) = $1,834,500 - 406,504.4 - 1,298,840 + 10,380.24

NPV (financing side effects) = $139,535.3

Therefore,

APV = -$75,528.8+ $139,535.3

APV = $64,006.56

Since the adjusted present value (APV) is positive, Knotts should undertake the project.