1. The 5-year project requires equipment that costs $100,000. If undertaken, the

Question

1. The 5-year project requires equipment that costs $100,000. If undertaken, the shareholders will contribute $20,000 cash and borrow $80,000 at 6% with an interest-only loan with a maturity of 5 years and annual interest payments. The equipment will be depreciated straight-line to zero over the 5-year life of the project. There will be a pre-tax salvage value of $5,000. There are no other start-up costs at year 0. During years 1 through 5, the firm will sell 25,000 units of product at $5; variable costs are $3; there are no fixed costs. Given Information r (debt) = 6%, r(asset)= 12%, r(equity)= 27.84%, Tax rate = 34%, Risk free rate = 2%, Debt to equity=4 What is the NPV of the project using the APV methodology?

Explanation / Answer

(i) Base Case NPV - (Consider unlevered project) 0 1 to 5 5 Investment cost -100000 Annnual Sales (25000 x 5) 125000 Less; Variable cost (25000 x 3) 75000 Contribution 50000 Less: Depreciation (100000/5) 20000 EBT 30000 Less: Tax @ 34% 10200 EAT 19800 Add: Depreciation 20000 CFAT 39800 Post tax salvage value (5000 x (1-0.34)) 3300 Net cash flows -100000 39800 3300 PV Factor Using r (Equity) 27.84% 1 2.54 0.292864135 PV of net cash flows -100000 101091.9807 966.4516459 Base case NPV = 2058.432328 (ii) PV of Interest tax savings Using RF as discount rate - Interest Each year 80000 x 6% = 4800 Tax savings 4800 x 34% 1632 PVAF(2%,5) 4.71 PV of tax savings 7692.365918 APV = Base Case NPV + PV of ITS - Flotation cost 2058.43 + 7692.37 9750.798246 Please provide feedback…. Thanks in advance…. :-)

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