Question

Wilma is considering opening a widget factory. The unlevered cost of equity for making widgets is 0.12. This factory would cost $26 million to set up, and would produce EBIT of $3 million per year for the foreseeable future. She is thinking of applying for a $3 million subsidized perpetual loan to finance this project. Complying with the auditing requirements of this loan would have a present value of $2 million. This loan would have a rate of 0.06, while the rate she could get from the bank is 0.07. Her tax rate is 0.31. What is the NPV of this project, using the APV method?

Answer 1

NPV using Adjusted Present Value =NPV of Earnings ,ie.after tax cash flows ,by discounting at the unlevered cost of equity PLUS PV of Tax savings due to Debt

ie. (Initial cost+PV of the perpetual EAT discounted at the unlevered cost of equity, 12%) ADJUSTED for the PV of tax savings due to interest expenses on the debt.

Where, PV of tax savings= Debt amt.*Interest % *Tax Rate

So,

ie. -26+((3*(1-31%)/0.12)+(2*7%*31%)=

-8.7066

millions