Question

Knotts, Inc., an all-equity firm, is considering an investment of $1.72 million that will be depreciated according to the straight-line method over its four-year life. The project is expected to generate earnings before taxes and depreciation of $598,000 per year for four years. The investment will not change the risk level of the firm. The company can obtain a four-year, 9.7 percent loan to finance the project from a local bank. All principal will be repaid in one balloon payment at the end of the fourth year. The bank will charge the firm $48,000 in flotation fees, which will be amortized over the four-year life of the loan. If the company financed the project entirely with equity, the firm’s cost of capital would be 12 percent. The corporate tax rate is 22 percent. Using the adjusted present value method, calculate the APV of the project. (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89)

Answer 1

Please refer to below spreadsheet for calculation and answer. Cell reference also provided.

A B C 1 Initial Investment $1,720,000.00 2 Tax rate 22% Before tax earnings After tax earnings Depreciation tax shield Project life Cost of capital (all equity) $598,000.00 $466,440.00 $94,600.00 4 5 6 7 4 8 12.00% 9 All Equity NPV -$1,431.71 10 11 Floation Cost Annual amortization of Floation cost Amoratization period (years) Tax rate Cost of Debt PV of Floation cost $48,000.00 $12,000.00 12 13 14 4 22% 15 16 9.7% $39,576.92 17 18 Loan Amount PV of Loan Financing (Benefit) $1,720,000.00 19 $117,108.90 20 21 $76,100.27 APV of Project 24

Cell reference -

A В C 1 Initial Investment Tax rate Before tax earnings After tax earnings Depreciation tax shield Project life Cost of capital (all equity) 1720000 0.22 598000 =C4* (1-C3) |-C2/4*С3 2 4 6 4 7 0.12 8 9 All Equity NPV -PV(C8,C7,-C5,0)+ PV (C16,C7,-C6,0)-C2 10 11 48000 Floation Cost 12 Annual amortization of Floation cost Amoratization period (years) Tax rate Cost of Debt 13 C12/4 4 0.22 0.097 |ЕC12-PV(С16,С14,-С13*С15,0) 14 15 16 17 PV of Floation cost 18 Loan Amount 19 C2 -C19-PV(C16,C14,-C19* C16*(1-c15),-C19,0) PV of Loan Financing (Benefit) 20 21 C10+C20-C17 APV of Project 22 23 24 st LC LC

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