Question

Wilma is considering opening a widget factory. The unlevered cost of equity for making widgets is 0.13. This factory would cost $27 million to set up, and would produce EBIT of $3 million per year for the foreseeable future. She is thinking of applying for a $3 million subsidized perpetual loan to finance this project. Complying with the auditing requirements of this loan would have a present value of $2 million. This loan would have a rate of 0.04, while the rate she could get from the bank is 0.08. Her tax rate is 0.42. What is the NPV of this project, using the APV method?

Answer #1

The net present value of this project = -7.32 million

**Explanation:**

Calculate the net present value of this project

Cost of equity K_{E} = 0.13

Cost of debt K_{D} = 0.08

Tax rate t_{C} = 0.42

Weight of debt W_{D} = Value of debt / Project cost

= 3 / 27

= 0.1111

Weight of Equity W_{E} = 1 - W_{D}

= 1 - 0.1111

= 0.8888

WACC = W_{E} * K_{E} + W_{D} *
K_{D} * (1 - t_{C})

= 0.8888 * 0.13 + 0..1111* 0.08* (1 - 0.42)

= 0.1207

PV of cash inflow = EBIT * (1 - t_{C}) / WACC

= 3 * (1 - 0.42) / 0.1207

= 14,415,907.2

Base case NPV = PV of cash inflow + PV on auditing - Project cost

= 14,415,907.2 + 2,000,000 - $25,000,000

= -8,584,093

Annual Tax shield on interest on bonds:

= $3M × 4/100) × .42

=.0504

Pesent value of Annual tax shield on interest on bonds = .0504/.04

=1.26M

Adjusted Present VAlue - Base case NPV + present value of Annual tax shield on interest on bonds

= -8,584,093 + 1,260,000

= -7,324,093

Wilma is considering opening a widget factory. The unlevered
cost of equity for making widgets is 0.13. This factory would cost
$27 million to set up, and would produce EBIT of $3 million per
year for the foreseeable future. She is thinking of applying for a
$3 million subsidized perpetual loan to finance this project.
Complying with the auditing requirements of this loan would have a
present value of $2 million. This loan would have a rate of 0.04,
while...

You are opening a carnival. Building the carnival will cost $15M
dollars, and the carnival will produce EBIT of $3M per year for the
foreseeable future. Your tax rate is 28%, your cost of unlevered
equity is 11%, and your cost of debt is 6%. In order to boost teen
employment, the State of Kansas is offering you an $8M perpetual
loan with an interest rate of 5%, but applying for this loan will
incur administrative costs of $500,000.
1)...

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