Consider a project to produce solar water heaters. It requires a $10 million investment and offers a level after-tax cash flow of $1.75 million per year for 10 years. The opportunity cost of capital is 12%, which reflects the project’s business risk. Assume that the project is financed with $5 million of debt and $5 million of equity. The interest rate is 8% and the marginal tax rate is 35%. The debt will be paid off in equal annual installments over the project’s 10-year life.
Required: (a) Calculate the Adjusted Present Value (APV).
(b) How does APV change if the firm incurs issue costs of $400,000 to raise the $5 million of required equity?
(c) Assuming that the solar water heaters project has a NPV, when all equity financing, of $500,000. To finance the project, $10 million in debt is issued with associated flotation costs of $200,000. For tax purposes, the flotation costs has to be amortized over the project's 10 year life. The debt is issued at 10% interest with the repayment of principal due in a lump sum at the end of the tenth year. As stated above, the firm's tax rate is 35%. Calculate the project's APV.
(d) Under what circumstances would it be better to use the Adjusted Present Value approach?