MVP Inc has produced rodeo supplies for over 20 years. The company currently has

Question

MVP Inc has produced rodeo supplies for over 20 years. The company currently has a debt-equity ratio of 50% and is in the 40% tax bracket. The required return on the firm’s levered equity is 16%. MVOP is planning to expand its production capacity. The equipment to be purchased is expected to generate the following unlevered cash flows (thus, not including any interest expense):

Year

Cash Flow

0

-18,000,000

1

5,700,000

2

9,500,000

3

8,800,000

The company has arranged a $9.3M debt issue to partially finance the expansion. Under the loan, the company would pay interest of 9% at the end of each year on the outstanding balance at the beginning of the year. The company would also make year-end principal payments of $3.1M per year, completely retiring the issue by the end of the third year. Using the adjusted present value method, should be company proceed with the expansion?

Year

Cash Flow

0

-18,000,000

1

5,700,000

2

9,500,000

3

8,800,000

Explanation / Answer

Now Calculate Net Present Value of Cash Flows Discounted ate 14.38%

Calculate NPV of Financial side effects

Since the adjusted present value of the project is positive, MVP should proceed with the expansion.

First of all we have to Calculate unlevered cost of equity rs=r0+ (B/S)(r0-rB)(1-TC) r0 = Required return on the equity of an unlevered firm rs = Required return on the equity of a levered firm 0.16 rB= The pretax cost of debt 0.09 TC = Corporate Tax Rate 0.4 B/S= Debt Equity Ratio 0.5 rs=r0+ (B/S)*(r0-rB)*(1-TC) 0.16=r0+(0.50)(r0-0.09)(1-0.40) 0.16= r0+(0.50r0-0.045)*0.60 0.16= r0+(0.50r0-0.045)*0.60 0.16= r0+0.30r0-0.027 1.30r0 = 0.187 r0= 14.38%

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