Gemini, Inc., an all-equity firm, is considering a $1.8 million investment that
ID: 2629853 • Letter: G
Question
Gemini, Inc., an all-equity firm, is considering a $1.8 million investment that will be depreciated according to the straight-line method over its four-year life. The project is expected to generate earnings before taxes and depreciation of $605,000 per year for four year. The investment will not change the risk level of the firm. The company can obtain a four-year, 8.6 percent loan to finance the project from a local bank. All principal will be repaid in one balloon payment at the end of the fourth year. The bank will charge the firm $55,000 in flotation fees, which will be amortized over the four-year life of the loan. If the company financed the project entirely with equity, the firms cost of capital would be 12 percent. The corporate tax rate is 34 percent.
Using the adjusted present value method, calculate the APV of the project. (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))
Explanation / Answer
investment 1800000 Earnings before tax and depreciation 605000 useful life 4 less : tax 205700 depreciation per annum 450000 Earnings before depreciation 399300 tax savings on depreciation 153000 Add : tax savings on depreciation 153000 Free cash flow to firm 552300 Discounting rate Year 12 Cash flow Dsic. Cash flow 0 1.00 -1800000 -1800000 1 0.89 552300 493125.00 2 0.80 552300 440290.18 3 0.71 552300 393116.23 4 0.64 552300 350996.63 NPV -122471.96 Base NPV -122471.96 Financing effect flotation cost 55000 interest to be paid =1800000*0.086 = 154800 amortised period 4 post tax interest 102168 per year 13750 tax savings on flotation cost 4675 -97493 assumed that 605000 cash flow is without considering interest outflow.hence financing effect will be post tax interest and not just tax savings on interest Discounting rate Year 8.6 Cash flow Dsic. Cash flow 0 1.00 1745000 1745000.00 1 0.92 -97493 -89772.56 2 0.85 -97493 -82663.50 3 0.78 -97493 -76117.40 4 0.72 -1897493 -1364146.09 NPV 132300.45 Adjusted present value = base npv + NPV of financing =-122471.96+132300.45 = 9828.5
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