\" Gemini, Inc., an all-equity firm, is considering a $1.7 million investment th

Question

" Gemini, Inc., an all-equity firm, is considering a $1.7 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 $595,000 per year for four years. The investment will not change the risk level of the firm. The company can obtain a four-year, 9.5 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 $45,000 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 30 percent. Using the adjusted present value method, determine whether the company should undertake the project."

Explanation / Answer

CALCULATION OF NPV:

Profit before tax and depreciation                                        = $595,000

Less: Depreciation ($1,700,000/4)                                        = 425,000

Profits before tax                                                                       170,000

Less: tax @ 30%                                                                       51,000

Profit after tax                                                                           119,000

Add: deprecation                                                                      425,000

Future cash flows                                                                    544,000

Present value factor @13% for 4 yrs                                        2.8745

Total discounted cash flows (544000 x 2.9745)                  1,618,128    

Less: Initial investment                                                        1,700,000  

Net present value                                                                   - 81,872    

Tax shield on the debt =

___________________________________________________________________________________

years                                                               1                                2                     3                 4                

Interest                                                      161,500                    161,500           161,500       1,61,500

Tax shield @30%                                        48,450                      48,450             48,450          48,450

Less: Floatation cost amortization               11,250                      11,250             11,250          11,250

Net benefit                                                   37,200                      37,200             37,200          37,200

PV factor                                                      0.8850                       0.7831             0.6931         0.6133

Discounnted cash flows                              32,922                      29,131              25,783          22815

Total discounted cash flows 32,922 + 29,131+ 25,783 + 22,815 = $110,651

APV = -81872 +110,651 =

Related Questions

Navigate

• Browse (All)
• Browse #
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.