Question

MVP, Inc., has produced rodeo supplies for over 20 years. The company currently has a debt–equity ratio of 70 percent and is in the 34 percent tax bracket. The required return on the firm’s levered equity is 15 percent. The company is planning to expand its production capacity. The equipment to be purchased is expected to generate the following unlevered cash flows:

  

Year	Cash Flow
0	−$18,500,000
1	5,750,000
2	9,550,000
3	8,850,000

  

The company has arranged a debt issue of $9.45 million to partially finance the expansion. Under the loan, the company would pay interest of 8 percent 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 $3,150,000 per year, completely retiring the issue by the end of the third year.

  

Calculate the APV of the project. (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Answer 1

APV = NPV (unlevered) + PV (interest tax shield)

Cost of levered equity, Rl = Ru + D/E x (1 - tax) x (Ru - Rd)

=> 15% = Ru + 0.7 x (1 - 34%) x (Ru - 8%)

=> Ru = (15% + 0.7 x 0.66 x 8%) / (1 + 0.7 x 0.66) = 12.79%

NPV (unlevered) = - 18,500,000 + 5,750,000 / (1 + 12.79%) + 9,550,000 / (1 + 12.79%)^2 + 8,850,000 / (1 + 12.79%)^3

= $273,411.31

Outstanding	Interest	Tax Shield
9450000	756000	257040
6300000	504000	171360
3150000	252000	85680

Interest Payment = Outstanding x Interest rate

Tax Shield = Tax Rate x Interest payment

PV (interest tax shield) = 257,040 / (1 + 8%) + 171,360 / (1 + 8%)^2 + 85,680 / (1 + 8%)^3 = $452,929.13

=> APV = 273,411.31 + 452,929.13 = $726,340.44