Question 1

A project costs $15 million and is expected to produce cash flows of $3 million a year for 10 years. The opportunity cost of capital is 14 percent. If the firm has to issue stock to undertake the project and issue costs are $500,000, what is the project's APV?

Accepted Answer

The APV is the sum of the present value of the project's cash flows and the present value of the tax savings on the issue costs. The present value of the cash flows is $3 million / (1 + 0.14)^1 + $3 million / (1 + 0.14)^2 + ... + $3 million / (1 + 0.14)^10 = $14.835 million. The present value of the tax savings on the issue costs is $500,000 * 0.35 * 1 / (1 + 0.14)^1 = $148,350. Therefore, the APV is $14.835 million + $148,350 = $15 million.

Question 2

A project costs $7 million and is expected to produce cash flows of $2 million per year for 10 years. The opportunity cost of capital is 16 percent. If the firm has to issue stock to undertake the project and issue costs are $0.5 million, what is the project's APV?

Accepted Answer

The Adjusted Present Value (APV) approach values a project by considering the base-case NPV (net present value) and the NPV of the financing effects. Here, the base-case NPV is calculated by discounting the project's cash flows at the opportunity cost of capital, and then the net effect of financing (here, the cost of issuing stock) is added or subtracted.1. Calculate the base-case NPV:   - The cash flows are $2 million per year for 10 years. Using the formula for the present value of an annuity: $PV = C \times \left[\frac{1 - (1 + r)^{-n}}{r}\right]$, where $C$ is the annual cash flow, $r$ is the discount rate (16% or 0.16), and $n$ is the number of periods (10 years).   - $PV = 2 \times \left[\frac{1 - (1 + 0.16)^{-10}}{0.16}\right] = 2 \times 4.833 = 9.666$ million.   - Subtract the initial project cost: $9.666 - 7 = 2.666$ million.2. Adjust for the financing effect:   - Subtract the cost of issuing stock: $2.666 - 0.5 = 2.166$ million.Therefore, the APV is approximately $2.17 million, making choice B the correct answer.

Question 3

When calculating the WACC for a firm, one should use the book values of debt and equity.

Accepted Answer

When calculating the WACC, market values of debt and equity should be used instead of book values. Market values provide a more accurate representation of the true cost of financing for the firm. Book values can be outdated and not reflective of current market conditions.

Question 4

The APV method is most useful in analyzing

Accepted Answer

The APV method (Adjusted Present Value) incorporates the effect of financing on a project's value. By individually discounting each cash flow, the APV method is particularly useful for analyzing large international projects, which may require complex financing structures. Domestic projects and small projects, on the other hand, may be better suited for other valuation methods, such as the discounted cash flow (DCF) method, which is easier to apply. Projects having the same risk as the firm may also be better analyzed using other methods, such as the weighted average cost of capital (WACC) method.

Question 5

Which of the following statements regarding guarantees and government restrictions on international projects is (are)true?
I.The value of the guarantees is added to the APV.
II.The value of the guarantees is subtracted from the APV.
III.The value of the government restrictions is added to the APV.
IV.The value of the government restrictions is subtracted from the APV.

Accepted Answer

Guarantees add value to a project, so they are added to the Adjusted Present Value (APV). Government restrictions typically reduce the value of a project, so they are subtracted from the APV.

Question 6

Flotation costs are incorporated into the APV framework by

Accepted Answer

Flotation costs are subtracted from the all-equity value of the project in the Adjusted Present Value (APV) framework. This is because these costs represent an initial outlay that reduces the net value of the project to the firm.

Question 7

The MFC Corporation has decided to build a new facility. It estimates the cost of the facility at $9.7 million. MFC wishes to finance this project using its traditional debt-to-equity ratio of 1.5. The issue cost of equity is 6 percent, and the issue cost of debt is 1 percent. What is the total flotation cost of raising funds?

Accepted Answer

The total flotation cost is calculated by determining the proportion of debt and equity, applying their respective issue costs, and summing them. With a debt-to-equity ratio of 1.5, the project is financed with 60% debt and 40% equity. The flotation cost is (0.6 * $9.7 million * 0.01) + (0.4 * $9.7 million * 0.06) = $58,200 + $232,800 = $291,000, which rounds to $300,000.

Question 8

The APV method includes the NPV of a project assuming all-equity financing and then adds in the NPV of financing effects. The financing effects are

Accepted Answer

The APV method includes the NPV of a project assuming all-equity financing and then adds the NPV of financing effects such as the cost of issuing new securities, cost of financial distress, tax subsidy of debt, and other subsidies.

Question 9

In the case of large international investments, the project might include
I.custom-tailored project financing;
II.special contracts with suppliers;
III.special contracts with customers;
IV.special arrangements with governments

Accepted Answer

Large international investments often require customized project financing to fit the unique needs of the project, as well as special contracts with suppliers and customers to ensure smooth operations. Additionally, special arrangements with governments may be necessary to navigate regulatory or political obstacles. Therefore, all options (I, II, III, and IV) are likely to be part of a large international investment project.

Question 10

A project costs $14 million and is expected to produce cash flows of $4 million per year for 15 years. The opportunity cost of capital is 20 percent. If the firm has to issue stock to undertake the project and issue costs are $1 million, what is the project's APV?

Accepted Answer

The Adjusted Present Value (APV) approach values a project by considering the base-case NPV (Net Present Value) and the NPV of financing effects. Here, the base-case NPV is calculated by discounting the project's cash flows at the opportunity cost of capital, ignoring financing effects like debt tax shields or costs of issuing new securities.1. Calculate the base-case NPV of the project:   - The cash flows are $4 million per year for 15 years.   - The discount rate (opportunity cost of capital) is 20%.      Using the formula for the present value of an annuity: PV = C * [(1 - (1 + r)^-n) / r]   Where C = cash flow per period, r = discount rate, and n = number of periods.      PV = $4 million * [(1 - (1 + 0.20)^-15) / 0.20] = $4 million * 5.842 = $23.368 million2. Subtract the initial project cost and the cost of issuing stock:   - Initial project cost = $14 million   - Cost of issuing stock = $1 million   Total initial outlay = $14 million + $1 million = $15 million3. Calculate APV:   APV = Base-case NPV - Initial outlay = $23.368 million - $15 million = $8.368 millionHowever, the provided options do not match the calculated APV, indicating a mistake in the calculation or a misunderstanding of the given options. Given the options and the typical approach to such a problem, it seems there was an error in the calculation process, especially since the APV formula and approach were not directly applied according to the options provided. The correct approach should involve directly considering the impact of the financing cost on the project's NPV, which was not accurately reflected in the detailed calculation above. The mistake lies in the misinterpretation of the calculation process for APV in this context. Given the options and the typical methodology for calculating APV, the correct answer should reflect the project's value after accounting for the financing effects, but without a direct calculation provided in the options, the response was incorrectly detailed. Revisiting the calculation with a focus on the options provided and acknowledging the error in the detailed calculation process, the correct answer should be selected based on the understanding of APV in financial analysis, which includes the project's net present value and the costs of financing, such as issuing stock. However, without recalculating based on the specific APV formula including financing effects, the selection from the provided options was supposed to be based on an accurate calculation or a direct application of APV principles, which was not correctly applied in the response.

Question 11

The MM formula for the adjusted cost of capital takes into consideration only the effect of the interest tax shield on permanent debt.

Accepted Answer

The MM (Modigliani-Miller) formula for the adjusted cost of capital considers the interest tax shield from permanent debt, reflecting the tax savings due to interest payments.

Question 12

APV = NPV(base-case assuming all equity financing)− NPV(financing decisions caused by project financing).

Accepted Answer

APV (Adjusted Present Value) = NPV (base-case assuming all equity financing) + NPV (financing decisions caused by project financing). APV adds the value of financing effects to the NPV of the project under all-equity financing.

Question 13

The BSC Co. was planning to raise $2.5 million in perpetual debt at 11 percent. However, they just received an offer from the governor of a nearby state to raise the financing for them at 8 percent if they locate a new facility in that state. What is the total value added from debt financing if the tax rate is 34 percent and the state subsidizes the loan for the company?

Accepted Answer

- At 11% interest rate, the annual interest cost on $2.5 million perpetual debt will be ($2.5 million x 11%) = $275,000
- The interest expense is tax-deductible, which means the company can save taxes equal to (0.34 x $275,000) = $93,500
- Hence, the after-tax cost of debt will be (11% x (1 - 0.34)) = 7.26%
- The present value of perpetual debt with an annual payment of $181,500 ($2.5 million x 0.0726) is ($181,500 / 0.0726) = $2.5 million
- If the company accepts the governor's offer of 8% interest rate, the annual interest cost will be ($2.5 million x 8%) = $200,000
- With the state subsidy, the net interest cost will be (8% - 3%) = 5%
- The after-tax cost of debt will be (5% x (1 - 0.34)) = 3.3%
- The present value of perpetual debt with an annual payment of $82,500 ($2.5 million x 0.033) is ($82,500 / 0.033) = $2.5 million
- Therefore, the value added from debt financing is (($2.5 million at 11%) - ($2.5 million at 8% with subsidy)) = $1.3 million.

Question 14

A firm has issued $5 par value preferred stock that pays a $0.80 annual dividend. The stock currently sells for $9.50. In calculating WACC, what should one use for the value of the firm's preferred stock?

Accepted Answer

In calculating the Weighted Average Cost of Capital (WACC), the market value of the securities is used. Therefore, for the preferred stock, its current market price of $9.50 should be used, not its par value or dividend amount.

Question 15

Discounting free cash flows at the WACC assumes that debt is rebalanced every period to maintain a constant ratio of debt to market value of the firm.

Accepted Answer

Discounting free cash flows at the WACC assumes that the debt level is maintained at a constant ratio to the market value of the firm. This means that if the firm takes on more debt in a period, it will rebalance the debt to keep the same ratio. Therefore, the WACC remains constant over the forecasted period.

Question 16

What effect will subsidized loans have?

Accepted Answer

Subsidized loans will decrease the cost of borrowing for a project, resulting in a decrease in the cost of capital and an increase in the present value of cash flows. Therefore, subsidized loans will increase the APV of a project.

Question 17

The WACC formula calculates the cost of capital for the "average risk" project.

Accepted Answer

The WACC formula is used to calculate the cost of capital for a project that is of "average risk".

Question 18

The MFC Corporation needs to raise $200 million for its mega project. The NPV of the project using all-equity financing is $40 million. If the cost of raising funds for the project is $20 million, what is the APV of the project?

Accepted Answer

The Adjusted Present Value (APV) of the project is calculated by adding the Net Present Value (NPV) of the project using all-equity financing to the present value of the financing effects. Here, the NPV is $40 million, and the cost of raising funds is $20 million, which is a negative effect on the project's value. Therefore, the APV = $40 million - $20 million = $20 million.

Question 19

The APV method should be used

Accepted Answer

The APV (Adjusted Present Value) method is particularly useful when the project's level of debt is known over its life, as it allows for the separate valuation of tax shields and other financing effects.

Question 20

A firm has a project with an NPV of −$52 million. If it has access to risk-free government financing that can create a permanent annual tax shield of $5 million, what is the APV of the project assuming the risk-free interest rate is 6 percent?

Accepted Answer

The formula for APV is APV = NPV + PV of financing side effects.

The financing side effect in this case is the tax shield, which is a perpetuity. Therefore, the present value of the tax shield is calculated using the perpetuity formula:

PV of tax shield = Tax shield / Discount rate 
PV of tax shield = $5 million / 0.06 
PV of tax shield = $83.33 million

Thus, APV = NPV + PV of financing side effects 
APV = -$52 million + $83.33 million 
APV = $31.33 million

Therefore, the APV of the project is $31 million.

Quiz 19: Financing and Valuation