The Adjusted Present Value (APV) Company has an investment opportunity to produc
ID: 2714150 • Letter: T
Question
The Adjusted Present Value (APV) Company has an investment opportunity to produce a new product that will require an investment in equipment of $24 million with a 4 year life and a salvage value of $5 million and will be depreciated straight-line to zero. The project will generate $60 million in revenue and entail $52 million in operating costs. The Company pays 34% in taxes. The firm is considering a change in capital structure so that it would maintain a debt ratio of 50% and pay 6% in interest on this debt. The firm’s beta is 1.5 and the market risk premium is 8.5% and the U.S. Treasury has a yield to maturity of 4%. You have been asked to determine whether the Company should accept this project and whether it should borrow money to do so. You also have a very skeptical boss who believes that the only way to value a project is to use the flow to equity approach.
Explanation / Answer
REVENUE = $60 MILLION
OPERATING COST = $52 MILLION
DEPRECIATION = $4.75 MILLION
EBIT = $3.25 MILLION
INTEREST = $0.4752 MILLION (24 * 50% * 6% * 66%) COD=3.96%
EBT = $2.7748 MILLION
TAX = 0.943432 MILLION
EAT = 1.831368 MILLION
COST OF EQUITY = 0.30675414 (16.75%) i.e 1.5*8.5 +4
EARNING = 1.52461386 MILLION
YES , COMPANY SHOULD ACCEPT THE PROJECT AND SHOULD BORROW MONEY AS COST OF DEBT(3.96%) IS LOWER THAN COST OF EQUITY(16.75%).
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