Question

Question 2 1 pts Roger has a levered cost of equity of 0.23. He is thinking of investing in a project with upfront costs of $6 million, which pays $1 million per year for the next 6 years. He is going to borrow $3 million to offset the startup costs at a rate of 0.04. His tax rate is 0.4. He will repay this loan at the end of the project. What is the NPV of this project, using the FTE method?

Answer 1

Answer:-

Q 2)

Using the FTE (Flow to Equity) method

LCF = UCF - (1 - tax rate) x interest rate x the amount of project financed by debt
LCF = Levered cash flow
UCF = Unlevered cash flow
tax rate = 0.4 = 40%
interest rate = 0.04 = 4%
amount financed by debt = $ 3 million

Unlevered cash flows amount to $ 6 million as there is an inflow of $ 1 million per year for 6 years

LCF = $ 6 million - ( 1 - 0.4 ) x 0.04 x $ 3 million
LCF = $ 6 m - 0.6 x 0.04 x $ 3 m
LCF = $ 6 m - 0.072
LCF = $ 5.928

Discounting the LCF by the levered cost of equity which is given as 0.23 or 23%

= $ 5.928 / 1.23
= $ 4.83 ( cash inflow)

Given the Upfront costs = $ 6 million of which $ 3 million is borrowed at the interest rate of 4% .

The initial cash outflow is = $ 3 million

The loan of $ 3 million at interest of 4% at the end of 6 years costs = $ 3 m x (1+0.04)⁶ = $ 3 m x 1.265 = $ 3.795 million
Discounting at the levered cost of equity of 0.23 or 23%
The NPV of this cash outflow = $ 3.795 / (1.23)⁶
= $ 3.795 / 3.46
NPV = $ 1.096 ( this is a cash outflow)

Therefore the total cash outflow = - $ 3 m  - $ 1.096 m = - $ 4.096 million

The Net present value (NPV) = - $ 3 m + - $ 1.096 m + $ 4.83 m = - $ 4.096 m + $ 4.83 m = $ 0.734 million.

NPV of the project = $ 0.734 million