Consider a project: Initial investment: $1,750,000 Perpetual (after-tax) cash fl

Question

Consider a project:

Initial investment: $1,750,000

Perpetual (after-tax) cash flows: $80,000

Tax rate: 35%

Risk free rate: 2%

Market return: 8%

Project equity beta: 1.45

The cost of debt is 8%

Debt is perpetual.

This project is financed with 85% debt and 15% equity, and the levels of debt and equity are expected to remain constant. The initial investment will be depreciated to zero via straight-line method over 8 years. What is the APV of the project? Explain using this example how capital structure decisions can influence capital budgeting decisions. Are there any other side effects of debt we should take into account?

Explanation / Answer

Cost of Equity=2+1.45*(8-2) 10.7 Cost of debt=(1-0.35)*8 5.2 WACC when D/B =85%/15% WACC=(0.85*5.2+0.15*10.7) 6.025 Initial Investment(A) 1750000 PV of perpetuity=80000/0.06025(B) 1327801 PV of Depriciation Annuity for 8 years=(1750000/8)*5.74

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