Question: MVP Inc has produced rodeo supplies for over 20 years. The company cur

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Question: MVP Inc has produced rodeo supplies for over 20 years. The company currently has a debt-equity ratio of 50% and is in the 40% tax bracket. The required return on the firm’s levered equity is 16%. MVOP is planning to expand its production capacity. The equipment to be purchased is expected to generate the following unlevered cash flows (thus, not including any interest expense):

Year Cash Flow 0 -18,000,000

Year Cash Flow 1 5,700,000

Year Cash Flow 2 9,500,000

Year Cash Flow 3 8,800,000

The company has arranged a $9.3M debt issue to partially finance the expansion. Under the loan, the company would pay interest of 9% at the end of each year on the outstanding balance at the beginning of the year. The company would also make year-end principal payments of $3.1M per year, completely retiring the issue by the end of the third year. Using the adjusted present value method, should be company proceed with the expansion?

Explanation / Answer

WACC of this project would be = 50% * 16% + 50% * 9% * (1-40%) = 10.70%

Since the debt of 9.3 million is raised to fund this project, we have to calculate cash flows after paying the interests for each year

So year 1 cash flow = 5.7 - 9.3 * 9% = 4.863 million

So year 2 cash flow = 9.5 - 6.2 * 9% = 8.942 million

So year 3 cash flow = 8.8 - 3.1 * 9% = 8.521 million

Note: Outstanding principle is reduced by $3.1 million each year as specified in the question

So NPV of this project is

= NPV(10.7%,A1:A3) - 18,000,000 = -28,855.30

Here cells A1 till A3 have Year 1 till year 3 cash flows

Since the NPV is negative, the company should not proceed with the expansion

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