Question

FOB Ltd. is considering an investment opportunity. It requires an initial investment of $4 million and is expected to receive after-tax cash flows of $2.2 million at the end otf year 1 and $2.8 million in year 2. This investment is expected to last for two years only. The cost of capital is 12 percent if it is all-equity financed. FOB intends to borrow $1 million at an annual cost of 8 percent. The loan must be repaid in two equal annual instalments. The payments will occur at the end of each year. Assume FOB has a marginal corporate tax rate of 30 percent. Required: (a) Calculate the base-case NPV of this investment. (3 marks) (b) Calculate the adjusted present value (APV) of this investment. (10 marks)

Answer 1

Since the investment is financed partly by Equity and partly by Debt, we have to calculate Weighted Average Cost of Capital to use it as discount rate:

Nature	Amount	Proportion	Cost	Tax Rate	WACC
Equity	3,000,000	75%	12%	0.000%	9.00%
Debt	1,000,000	25%	8%	30.000%	1.40%
	4,000,000	100%			10.40%

Assuming After Tax Cash flows does not include Loan repayment

Year	Initial Investment	After Tax Cash Flows	Loan Repayment	CashFlow	[email protected]%	DCF
0	-4,000,000			-4,000,000	1.0000	-4,000,000.0
1		2,200,000	-500,000	1,700,000	0.9058	1,539,855.1
2		2,800,000	-500,000	2,300,000	0.8205	1,887,077.3
				-		-573,068
				BaseCase NPV		Adjusted NPV

Assuming After Tax cash flows include Loan repayment also:

Year	Initial Investment	After Tax Cash Flows	CashFlow	[email protected]%	DCF
0	-4,000,000		-4,000,000	1.0000	-4,000,000.0
1		2,200,000	2,200,000	0.9058	1,992,753.6
2		2,800,000	2,800,000	0.8205	2,297,311.5
			1,000,000		290,065
			BaseCase NPV		Adjusted NPV