Question

Violet Sky Aviation is evaluating a 1-year project that would involve an initial investment in equipment of 39,500 dollars and an expected cash flow of 42,900 dollars in 1 year. The project has a cost of capital of 7.69 percent and an internal rate of return of 8.61 percent. If Violet Sky Aviation were to use 39,500 dollars in cash from its bank account to purchase the equipment, the net present value of the project would be 338 dollars. However, Violet Sky Aviation has no cash in its bank account, so using money from its account is not possible. Therefore, the firm would need to borrow money to raise the 39,500 dollars. If Violet Sky Aviation were to borrow money to raise the 39,500 dollars, the interest rate on the loan would be 6.35 percent. Violet Sky Aviation would receive 39,500 dollars from the bank at the start of the project and would pay 42,008 dollars to the bank in 1 year. What is the NPV of the project if Violet Sky Aviation borrows 39,500 to pay for the project?

Answer 1

1.NPV of the project if Violet Sky Aviation borrows 39,500 to pay for the project

will be the SAME $ 338

as interest on debt(42008-39500)=$ 2508   is a FINANCING activity &

is not considered as part of firm's operating or free cash flows (OCF& FCFs)

2.But it is part of FCFE--Free cash flow to equity

then, NPV of the project if Violet Sky Aviation borrows 39,500 to pay for the project

will be the base case NPV -PV of interest expense (As tax% is not known)

Interest expense=42008-39500= 2508

ie. 338-(2508/1.0769^1)=

-1991

If Tax rate is given,

NPV=338+Interest tax shield (Interest expense*Tax Rate)