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.
a) Suppose the project is financed with $5 million of debt and $5 million of equity. The interest rateis 8% and the marginal tax rate is 35%. The principal of the debt will be paid off in equal annual installments over the project's 10-year life. Calculate APV.
b) How does APV change if the firm incurs issue costs of $400,000 to raise the $5 million of required equity?