Suppose your friend, Pat, approaches you with a plan to get in on the solar pane

Question

Suppose your friend, Pat, approaches you with a plan to get in on the solar panel leasing business. Pat has identified an opportunity to acquire panels sufficient to power 25 homes. On average, Pat estimates that your enterprise will incur a cost of $1,000 for each installation. After that, each home installation will operate maintenance free and generate approximately $50 per month of revenue for 10 years. Assume that due to the rapid rate of technological depreciation, there will be neither demand nor salvage value for these solar panels at lease expiry.

Assume you’ll face a 40 percent tax rate. For tax purposes, you’ll be able to depreciate the total cost of equipment and installation over 5 years in a straight-line manner. Your required return can be estimated from Solarplex, a publicly traded pure-play solar panel leasing company with a beta of 2 and a debt-to-equity ratio of 1. You estimate that returns on a balanced market portfolio are 12 percent and the risk-free rate of borrowing is 4 percent.

Suppose, first, that Pat proposes you form an all-equity enterprise to invest in this opportunity. What is the maximum price you should pay for this inventory of panels? Report annual cash flows, even if you decide to use a compact formula for direct calculation. Use the APV/WACC method (recall, they’re the same for a firm w/ no debt).

Suppose the seller is asking $50,000 for the total inventory of solar panels. Additionally, assume you can borrow $25,000 at 8 percent in the form of a five-year, interest-only loan, with the total principal retired via a balloon payment due in year 5. Does this investment make sense? Report annual cash flows, even if you decide to use a compact formula for direct calculation. Briefly explain why you are using the computational method chosen. (Hint: you will need to decide to use the APV or WACC formula. It is possible to compute either / both. But be careful -- given the nature of the debt-share-of-value in this project, one of these approaches is much more complicated than the other.)

Finally, assume that after lengthy negotiations, the seller will not take less than $42,000 for the panels you need. Through continuing research, however, Pat discovers that one-in-ten firms that have gone into this business have gone bankrupt. What do you recommend now? (Note: you’ll have to make an assumption regarding the magnitude of financial distress costs in the event of bankruptcy.)

Explanation / Answer

Soln :

Please refer the table for the solution:

Max. Price to pay = $25000 +28760.42 = $53761

Now, in case if Debt is to be introduced, we need to calculat the APV (adjusted Present value need to be calculated)

APV = NPV + PV of profit from debt financing

Or we can get the APV by the calculation given in the below table :

WACC = 14 % by using the cost of debt and cost of equity.

As NPV = $5387 and profitable, investment does make sense.

Lets calculate the financial distress cost into consideration , as it is given that 1 in 10 firms will go bankrupt, means 10% of the debt = 2500

So, still we will add into the NPV the cash flow comes positive, we can recommend to go into th business.

Year 0.00 1.00 2.00 3.00 4.00 5.00 6.00 7.00 8.00 9.00 10.00 Cash outflow -25000.00 0 Cash inflow 15000 15000 15000 15000 15000 15000 15000 15000 15000 15000 Depreciation -5000 -5000 -5000 -5000 -5000 Net earning before tax 10000.00 10000.00 10000.00 10000.00 10000.00 15000.00 15000.00 15000.00 15000.00 15000.00 TaX 4000 4000 4000 4000 4000 6000 6000 6000 6000 6000 Profit after tax 6000.00 6000.00 6000.00 6000.00 6000.00 9000.00 9000.00 9000.00 9000.00 9000.00 Rate of return CAPM= (market premium)*Beta + risk free rate 20 20 20 20 20 20 20 20 20 20 Discount rate 1.2 1.2 1.2 1.2 1.2 1.2 1.2 1.2 1.2 1.2 Net present value -25000.00 5000 4166.67 3472.22 2893.52 2411.27 3014.08 2511.73 2093.11 1744.26 1453.55 Total NPV of project 3760.41

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