Consider a project to produce solar water heaters. It requires a $10 m

QUESTION

Consider a project to produce solar water heaters. It requires a $10 million investment and offers a levelafter-tax cash flow of $1.75 million per year for 10 years. The opportunity cost of capital is 12%, whichreflects the projects business risk.a) Suppose the project is financed with $5 million of debt and $5 million of equity. The interest rateis 8% and the marginal tax rate is 35%. The principal of the debt will be paid off in equal annualinstallments over the projects 10-year life. Calculate APV.b) How does APV change if the firm incurs issue costs of $400,000 to raise the $5 million ofrequired equity?
a) APV = Net present value (NPV) + Present value of debt financing tax advantage NPV = Cash outfloe + Annual cash inflow*(1-(1+i)^-n)/i -10+1.75*(1-(1+.12)^-10)/.12 = -.1121 Mill Present value of debt financing tax advantage = Debt*Interest rate*Tax rate*(1-(1+i)^-n)/i = 5*.08*.35*(1-(1+.08)^-10)/.08 = .9394 Mill APV = -.1121 + .9394

= 0.8273 Mill. b)Present value of debt financing tax advantage = Debt*Interest rate*Tax rate*(1-(1+i)^-n)/i Issue cost *(1-tax) =5*.08*.35*(1-(1+.08)^-10)/.08 .4*(1-.35) = .6794 Mill APV = -.1121 + .6794 = 0.5673 Mill.

ANSWER:

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