Question

Zoso is a rental car company that is trying to determine whether to add 25 cars to its fleet. The company fully depreciates all its rental cars over five years using the straight-line method. The new cars are expected to generate $175,000 per year in earnings before taxes and depreciation for five years. The company is entirely financed by equity and has a 35 percent tax rate. The required return on the company's unlevered equity is 13 percent, and the new fleet will not change the risk of the company. Additional assumptions: depreciation tax shield is treated as riskless; the risk-free rate is 8%

Answer 1

The Solution to part b)

Unlevered cost of Equity = 13%

Calculation of Unlevered Free Cash Flow to Firm

Earnings before taxes and depreciation	$ 175,000
Less: Depreciation [ $ 480,000 / 5 ]	$ 96,000
Net Operating Profit	$ 79,000
Less: Tax @ 35%	$ 27,650
Net Operating Profit after taxes	$ 51,350
Add: Depreciation	$ 96,000
Less: Capex / additional WC required every year	$ 0
Unlevered Free Cash Flow to Firm	$ 147,350

Now, based on above, we can calculate Unlevered Net Present Value as:

=[ Unlevered Free Cash Flow to Firm * Cumulative discount factor for 1-5 years @ Unlevered cost of equity ] - Initial Investment Outlay

= [ $ 147,350 * Cumulative discount factor for 1-5 years @ 13% ] - $ 480,000

= [ $ 147,350 * 3.5172 ] - $ 480,000

= $ 518,259 - $ 480,000

= $ 38,259.42

Now, we will calculate the Present value of Tax Saving on Interest payments as:

The Company can issue $390,000 @ 8% debt to finanace the project which will be repaid in one lump-sum installment at the end of 5th year. Hence, the Present value of Tax Saving on Interest payments will be:

	Year 1	Year 2	Year 3	Year 4	Year 5
Principal Outstanding at the beginning of the year	$ 390,000	$390,000	$ 390,000	$ 390,000	$ 390,000
Interest Expense @ 8%	$ 31,200	$ 31,200	$ 31,200	$ 31,200	$ 31,200
Tax saving on interest @ 35%	$ 10,920	$ 10,920	$ 10,920	$ 10,920	$ 10,920
PV discount factor @ 8%	0.9259	0.8573	0.7938	0.7350	0.6806
PV of Tax Saving on Interest	$10,110.83	$9361.72	$8668.30	$8026.20	$7432.15

Hence, the total present value of Tax saving on Interest is $ 43,599.19

Thus,

Adjusted Present Value of the project will be = Unlevered Net Present Value + Present Value of Tax saving on Interest

= $ 38,259.42 + $ 43,599.19

= $ 81,858.61