Question

Suppose that XYZ Corp is considering financing a project with only equity. The project’s unlevered cost of capital is 10%. The project will require a $1000 initial investment today and pay incremental free-cash-flows of $100 in perpetuity starting the end of the next year. If the firm were to finance the project with debt so that its D/E ratio is 0.50 how will the NPV of the project change? Assume the interest rate on the new debt will be 3%, and the firm faces a 21% tax rate. Round your answer to two decimals.

What is the value of the interest tax-shield created by the new debt?

Answer 1

Cost of levered equity = Cost of unlevered equity + (1-T)*D/E * (Cost of unlevered - Cost of debt)

Cost of levered equity = 10% + (1-21%) *(10%- 3%) = 15.53%

WACC of the project = 15.53% * 2/3 + 3% *(1-21%)* 1/3 = 11.14%

Given, project investment = $ 1000

Debt in the investment = 0.5 * 1000 = $ 500

Interest rate = 3%

Tax rate = 21%

Value of the interest tax shield (ITS) = 500 * 3% * 21% = $ 3.15

NPV of unlevered cash flows = -1000 + 100/0.1 = 0

NPV after debt is added = NPV of unlevered cash flows + PV of ITS = 0+ 3.15/0.1 = $ 31.5