Question

Digital Organics (DO) has the opportunity to invest $1.03 million now (t = 0) and expects after-tax returns of $630,000 in t = 1 and $730,000 in t = 2. The project will last for two years only. The appropriate cost of capital is 11% with all-equity financing, the borrowing rate is 7%, and DO will borrow $330,000 against the project. This debt must be repaid in two equal installments of $165,000 each. Assume debt tax shields have a net value of $0.20 per dollar of interest paid. Calculate the project’s APV. (Enter your answer in dollars, not millions of dollars. Do not round intermediate calculations. Round your answer to the nearest whole number.)

Answer 1

Answer:

Step 1:

Calculate Base NPV:

Year 0 : Initial investment = $1.03 million = $1,030,000

Year 1: Cash inflow = $630000

Year 2: Cash Inflow = $730,000

NPV = 630000 / 1.11 + 730000 / 1.11^2 - 1030000 = $130,051.94

Step 2:

Calculate present value of Interest tax shield:

Year 1:

Interest in Year 1 = 330000 * 7% = $23,100

Interest tax shield = 23100 * 20% = $4,620

Year 2:

Loan oustanding = 330000 - 165000 = $165,000

Interest in Year 2 = 165000 * 7% = $11,550

Interest tax shield = 11550 * 20% = $2,310

Present value of Interest tax shield = 4620 / 1.11 + 2310 / 1.11^2 = $6037.01

Step 3:

APV

Adjusted present value = $130,051.94 + $ 6037.01 = $136,088.95

Project’s APV = $136,089