A company considers to undertake a 2-year project that requires an initial investment (at t=0) of 1.5 (all cash flows in $million). Expected (after-tax) revenues are 0.25 in year 1 (at t=1) and 1.6 in year two (at t=2). The company's cost of capital is 12%, and its cost of debt is 6%. The company is 50% equity financed. The risk-free rate is 4%. Assume that the project is a carbon copy of the firm.
a. Explain, in two or three sentences, this last assumption. Determine the Net Present Value (NPV) of the project. Is the project acceptable according to the NPV-rule? So far we ignored tax deductions. Suppose the effective tax rate is 35%.
b. Determine the (after-tax) Weighted Average Cost of Capital (WACC) for the project, and adapt your calculation of NPV in part a on the basis of this WACC value. Alternatively, one could determine the present value of the project's tax shield directly, and then compute the Adjusted Present Value (APV) of the project. The outcome will depend on the level of debt assigned to the project.
c. Explain in one or two sentences the difference between the ‘debt rebalanced' financing rule and the ‘debt fixed' financing rule. Which one corresponds best to (after-tax) WACC calculations?
d. The project's debt level is set equal to 0.75 in year 0, and 0.71 in year 1. Is this in line with the ‘debt fixed' rule? Compute the corresponding present value of the tax shield, and compare this to your answer in part b. Is the project acceptable according to the Adjusted Present Value (APV)-rule?