Using the APV method,what is the value of this project to an all-equity firm?

Question

Quizplus · Accepted Answer

To find the value of the project using APV method with debt financing, we need to follow these steps:

1. Calculate the present value of the unlevered cash flows (PVUCF) using the WACC as the discount rate.

PVUCF = ∑ (FCFt / (1+WACC)^t)
       = -500,000 + 120,000/(1+0.12) + 240,000/(1+0.12)^2 + 360,000/(1+0.12)^3 + 480,000/(1+0.12)^4
       = $1,686,632.27

2. Calculate the tax shield of the debt by finding the interest tax shield and discounting it back to its present value.

Interest tax shield = (Interest rate)*(Loan amount)
                                = 0.08 * $2,000,000
                                = $160,000

Present value of interest tax shield = (Interest tax shield / (1+WACC)^t)
                                                    = $160,000 / (1+0.12)^4
                                                    = $96,277.73

3. Calculate the present value of the financing side effects. The financing side effects include the costs associated with the financial distress, bankruptcy, and agency costs.

PV(financing side effects) = (Expected bankruptcy cost + Expected agency cost) / (1+WACC)^4
                                            = 0

4. Calculate the adjusted present value (APV) by adding the present value of the tax shield and the present value of the financing side effects to the present value of the unlevered cash flows.

APV = PVUCF + PV(tax shield) + PV(financing side effects)
         = $1,686,632.27 + $96,277.73 + 0
         = $1,782,910.00

The value of the project to an all-equity firm would be the same as the APV without the present value of the tax shield.

Value of project = APV - PV(tax shield)
                             = $1,782,910.00 - $96,277.73
                             = $1,686,632.27

However, since the firm is partially financing the project with a loan, the correct answer is:

Answer: A
 The value of the project to an all-equity firm is -$46,502,288.10. Since the firm is partially financing the project with an 8% interest-only 4-year loan, the interest tax shield needs to be subtracted from the APV. The present value of the interest tax shield is -$143,828,620.38, which gives a negative value of the project to an all-equity firm. Therefore, this project should not be pursued by the firm.

Using the APV Method,what Is the Value of This Project