Question

You are evaluating a project that requires an investment of $101 today and guarantees a single cash flow of $119 one year from now. You decide to use 100% debt financing, that is, you will borrow $101. The risk-free rate is 7% and the tax rate is 26%. Assume that the investment is fully depreciated at the end of the year, so without leverage you would owe taxes on the difference between the project cash flow and the investment, that is, $18. a. Calculate the NPV of this investment opportunity using the APV method. b. Using your answer to part (a), calculate the WACC of the project. c. Verify that you get the same answer using the WACC method to calculate NPV. d. Finally, show that flow-to-equity method also correctly gives the NPV of this investment opportunity.

          You are evaluating a project that requires an investment of $101 today and guarantees a single cash flow of $119 one year from now. You decide to use 100% debt financing, that is, you will borrow $101. The risk-free rate is 7% and the tax rate is 26%. Assume that the investment is fully depreciated at the end of the year, so without leverage you would owe taxes on the difference between the project cash flow and the investment, that is, $18.
a. Calculate the NPV of this investment opportunity using the APV method.
b. Using your answer to part (a), calculate the WACC of the project.
c. Verify that you get the same answer using the WACC method to calculate NPV.
d. Finally, show that flow-to-equity method also correctly gives the NPV of this investment opportunity.

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You are evaluating a project that requires an investment of 101 today and guarantees a single cash flow of119 one year from now. You decide to use 100% debt financing, that is, you will borrow $101. The risk-free rate is 7% and the tax rate is 26%. Assume that the investment is fully depreciated at the end of the year, so without leverage you would owe taxes on the difference between the project cash flow and the investment, that is, $18.
a. Calculate the NPV of this investment opportunity using the APV method.
b. Using your answer to part (a), calculate the WACC of the project.
c. Verify that you get the same answer using the WACC method to calculate NPV.
d. Finally, show that flow-to-equity method also correctly gives the NPV of this investment opportunity.

Added by Richard W.

Horngren’s Cost Accounting

Srikant M. Datar, Madhav V. Rajan 16th Edition

Instant Answer

Solved by Expert Madhur L

11/07/2023

Step 1

To calculate the NPV using the APV method, we need to consider the tax shield from debt financing. The tax shield is the tax savings from deducting interest expenses from taxable income. The interest expense on the debt is $101 * 7% = $7.07. The tax shield is Show more…

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is fully depreciated at the end of the year, so without leverage you would owe taxes on the difference between the project cash flow and the investment, that is, $18. a. Calculate the NPV of this investment opportunity using the APV method. b. Using your answer to part (a), calculate the WACC of the project. c. Verify that you get the same answer using the WACC method to calculate NPV. d. Finally, show that flow-to-equity method also correctly gives the NPV of this investment opportunity. You are evaluating a project that requires an investment of $101 today and guarantees a single cash flow of $119 one year from now. You decide to use 100% debt financing, that is, you will borrow $101. The risk-free rate is 7% and the tax rate is 26%. Assume that the investment is fully depreciated at the end of the year, so without leverage you would owe taxes on the difference between the project cash flow and the investment, that is, $18. b. Using your answer to part (a), calculate the WACC of the project. c. Verify same answer using the WACC method to calculate NPV. correctly gives the NPV of this investment opportunity.

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Transcript

00:01 Hello students, here is a question.

00:02 S fandry enterprises is considering a new 3 year expansion project that requires an initial fixed asset investment of $2 .18 million.

00:11 So, the fixed asset will be depreciated straight line to zero over 3 years of a tax life after which the time will be worthless.

00:18 The project is estimated to generate $1 .645 million.

00:23 The annual sales with a cost of $610 ,000.

00:26 The project required the initial investment in net working capital of $250 ,000.

00:31 And the fixed asset will be the market value of $180 ,000.

00:35 At the end of a project, the tax rate is 21%.

00:38 And what is the project's year zero for the next cash flow for year 1, 2 and 3? the negative answer should be indicated by a minus sign.

00:47 Do not round immediate calculation and enter your answer.

00:50 So, the second is if it required a return of 12%, what is the project's npv? so, calculate and round off your answers to do decimal places of a cash flow.

00:59 So, first is a cash flow for the year 1, 2, 3 and the npv we have to calculate here.

01:05 So, let us solve this problem.

01:12 So, here the asset investment will be asset investment is $2 ,180 ,000.

01:26 Then estimated annual sale estimated annual sales is $1 ,645 ,000.

01:40 Then we have to divide these two, we get cost.

01:51 So, cost is 61 ,000 sorry 610 ,000.

01:58 So, cost and sales we have to divide...

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