Question

Company J is considering a project with a 4-year lifespan. The initial cash flow estimate is $125million in the first year increasing by $125million in each of the years 2 through 4. To begin the project, the company will need to invest $1billion dollars. Company J would like to cover the initial investment amount with existing internal resources and thereby not borrow. As such it remains an all-equity firm. The unlevered cost of its equity is 10%, similar to other firms in the industry sector. There will be no terminal value of significance at the end of year 4. Using the domestic APV equation below, construct a spreadsheet model to determine whether it makes sense for Company J to proceed with this project. Please see an example for an APV spreadsheet at the Corporate Finance Institute website. You should attach your spreadsheet below. APV=Σt=1T((OCFt)(1−τ)(1+Ku)t+τDt(1+i)t+τIt(1+i)t)+TVT(1+Ku)T−CoAPV=Σt=1T((OCFt)(1−τ)(1+Ku)t+τDt(1+i)t+τIt(1+i)t)+TVT(1+Ku)T−Co Part 2: Now, imagine that company j finances the project with $600,000,000 of debt at= 8 percent. As such the company becomes a levered firm due to its acquisition of debt. What do the debt and related interest expense mean for the project if the tax rate is 40 percent? Update your spreadsheet model from above to demonstrate the effect of this debt on your decision.

Answer 1

APV of the project=

-1+(0.125*(1-40%)/1.1^1)+(2*0.125*(1-40%)/1.1^2)+(3*0.125*(1-40%)/1.1^3)+(4*0.125*(1-40%)/1.1^4)=

-0.433901

Billions

If company J finances the project with

600000000/1000000000=

60%

debt,

then the cost to discount the project will be the WACC ,ie.

(wt. D*Kd)+(wt.e*Ke)

ie.(60%*8%*(1-40%))+(40%*10%)=

6.88%

Now the above cash flows+ the interest tax shields available every year , will be discounted at this 6.88%

The annual interest tax shields will be 0.6 bln.*8%*40%=0.0192 blns.

So, including this , in the above cash flow:

APV= -1+((0.125*(1-40%)+0.0912)/1.0688^1)+((2*0.125*(1-40%)+0.0192)/1.0688^2)+((3*0.125*(1-40%)+0.0192)/1.0688^3)+((4*0.125*(1-40%)+0.0192)/1.0688^4)=

-0.251757

Billions

Interest expenses are financing cash flows & hence not subtracted from the given cash flows

but tax shields-ie. Savings in tax-cash outflow because of interest expenses, are cash savings & hence cash inflow.

The resultant cash flows are now, discounted taking into account the after-tax cost of debt.

So,

What do the debt and related interest expense mean for the project

The APV increases (ie. Decrease in Negative APV) because of :

cash savings in tax expenses which creates value for the firm &

the lesser overall cost of capital--(used to discount cash flows)-- due to the inclusion of debt in the funding structure.