Suppose your friend, Pat, approaches you with a plan to get in on the solar pane
ID: 2749058 • Letter: S
Question
Suppose your friend, Pat, approaches you with a plan to get in on the solar panel leasing business. Pat has identified an opportunity to acquire panels sufficient to power 25 homes. On average, Pat estimates that your enterprise will incur a cost of $1,000 for each installation. After that, each home installation will operate maintenance free and generate approximately $50 per month of revenue for 10 years.
Assume that due to the rapid rate of technological depreciation, there will be neither demand nor salvage value for these solar panels at lease expiry.
Assume you'll face a 40 percent tax rate. For tax purposes, you'll be able to depreciate the total cost of equipment and installation over 5 years in a straight-line manner.
Your required return can be estimated from Solarplex, a publicly traded pure-play solar panel leasing company with a beta of 2 and a debt-to-equity ratio of 1. You estimate that returns on a balanced market portfolio are 12 percent and the risk-free rate of borrowing is 4 percent.
Suppose, first, that Pat proposes you form an all-equity enterprise to invest in this opportunity. What is the maximum price you should pay for this inventory of panels? Report annual cash flows, even if you decide to use a compact formula for direct calculation. Use the APV/WACC method (recall, they're the same for a firm w/ no debt).
Suppose the seller is asking $50,000 for the total inventory of solar panels. Additionally, assume you can borrow $25,000 at 8 percent in the form of a five-year, interest-only loan, with the total principal retired via a balloon payment due in year 5. Does this investment make sense? Report annual cash flows, even if you decide to use a compact formula for direct calculation. Briefly explain why you are using the computational method chosen. (Hint: you will need to decide to use the APV or WACC formula. It is possible to compute either
/ both. But be careful -- given the nature of the debt-share-of-value in this project, one of these approaches is much more complicated than the other.)
Explanation / Answer
Estimating the required rate return from the data for Solarplex:
Since the suggestion is to have only equity, the cost of equity (ungeared) has to be estimated from the figures of Solarplex.
Unlevered beta = levered beta /[(1 + D(1-t)/E)] = 2/[(1+(1-0.4)] = 2/1.6 = 1.25
Now the required return for the all equity firm = 4 + 1.25(12 - 4) = 14%,
Discounting the cash flows we get the PV as:
PV of annual cash flows for the first five years = 11000* PVIFA (14,5) = 11000*3.433 = 37,763
PV of annual cash flows - 6th year to 10th year = 9000*PVIFA (14,5) * PVIF(14,5)=9000*3.433*0.519= 16035.54
TOTAL = 53,798.54
This 53,798.54 should be 86.268% of the max value payable for the panels. Hence, the maximum that can be paid
= 53798.54/.86268 = 62,362.10 $
The % of 86.268 is obtained by subtracting from 100% the P{V of tax shield of 40% on the depreciation of 10% for the first 5 years. = 100 - (10*0.4*3.433)
The yearly cash flows are worked out as under;
IF THE PANELS ARE PURCHASED FOR 50000$, WITH A LOAN OF 25000 @ 8%:
The first 5 years cash flows will increase by tax shield on addl depn of 10000 = 0.4*10000= 4000
So PVs for finding Base case NPV
1st five years = 15000*3.433 = 51495.00
6-10years as previously calculated = 16035.54
Total PV 67530.54
Less investment at t0 75000.00 (50000of panels + 25000 for installation)
Base case NPV (-)7469.46
Less Value of tax shield = 7986.00 [25000*.08*PVIFA(8,5)] = 2000*3.993= 7986]
discounted at 8 %
Adjusted PV 516.54
As the adjusted PV is positive this investment makes sense.
Adjusted PV method is chosen as it highlights the advantage arising out of debt more distinctly, by separating the cash flows arising out of debt.
Years 1 to 5 Years 6 to 10 Revenue 15000 15000 Depreciation 5000 0 PBT 10000 15000 tax @ 40% 4000 6000 PAT 6000 9000 add depreciation 5000 0 CASH FLOWS 11000 9000Related Questions
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