Gemini, Inc., an all-equity firm, is considering an investment of $1.75 million
ID: 2658533 • Letter: G
Question
Gemini, Inc., an all-equity firm, is considering an investment of $1.75 million 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 $609,000 per year for four years. The investment will not change the risk level of the firm. The company can obtain a four-year, 9 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 $59,000 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 firm’s cost of capital would be 13 percent. The corporate tax rate is 34 percent.
Using the adjusted present value method, calculate the APV of the project
Gemini, Inc., an all-equity firm, is considering an investment of $1.75 million 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 $609,000 per year for four years. The investment will not change the risk level of the firm. The company can obtain a four-year, 9 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 $59,000 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 firm’s cost of capital would be 13 percent. The corporate tax rate is 34 percent.
Explanation / Answer
Step I - Compute base case NPV
Compute base case NPV and ignore interest tax shield and flotation costs.
Now, we discount these using the 100% equity cost of capital.
Base case NPV = (-)Initial Investment + Annual OCF x PVIFA (13%, 4) = (-)$1,750,000 + $550,690 x 2.97447132552 = (-)$111,988.38575
Step II - Present value of tax savings on interest
Annual interest tax savings = $1,750,000 x 9% x 34% = $53,550
Present value of tax savings using debt rate as the discount rate = $53,550 x PVIFA (9%, 4) = $53,550 x 3.23971987702 = $173,486.999414
Step III - Flotation costs net of present value of tax shield
Annual tax shield on flotation costs amoritzation = ($59000 / 4) x 34% = $5015
Flotation costs net of present value of tax shield using debt rate as the discount rate = $59000 - $5015 x PVIFA (9%, 4) = $59000 - $5015 x 3.23971987702 = $42,752.8048168
Step IV - APV
APV = Base case NPV + Present value of tax savings on interest - Flotation costs net of Present value of tax shield
or, APV = (-)$111,988.38575 + $173,486.999414 - $42,752.8048168 = $18,745.808848 or $18,745.81
Annual OCF Earnings before taxes and depreciation $609,000 Less: Depreciation [ $1,750,000 / 4 ] $437,500 Earnings before taxes $171,500 Less: Taxes @34% $58,310 Net Income $113,190 Add: Depreciation $437,500 Annual Operating cash Flow (OCF) $550,690Related Questions
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