Continuing on from Question 1:

ABC is still considering investing in the project with the initial cost of $560,000 and that will earn unlevered free cash flows (FCFF) of $96,000 per year in perpetuity. The unlevered cost of capital is still 20% and the tax rate is 40%.

Assume instead of funding with 100% equity, ABC funds the project with $280,000 in perpetual debt (wtih an interest rate of 10%) and the remainder of funding will be with equity.

What is the NPV of the levered project using the APV method?

Question

Continuing on from Question 1:

ABC is still considering investing in the project with the initial cost of $560,000 and that will earn unlevered free cash flows (FCFF) of $96,000 per year in perpetuity. The unlevered cost of capital is still 20% and the tax rate is 40%.

Assume instead of funding with 100% equity, ABC funds the project with $280,000 in perpetual debt (wtih an interest rate of 10%) and the remainder of funding will be with equity.

What is the NPV of the levered project using the APV method?

BlackTom AI · Accepted Answer

We start by separating the project value from the financing effects, following the Adjusted Present Value (APV) approach.

First, compute the value of the project as if it were funded with 100% equity (the unlevered case).
- The project generates unlevered free cash flows to the firm (FCFF) of $96,000 per year in perpetuity.
- With an unlevered cost of capital of 20%, the value of the project (as an all-equity firm) is PV = FCFF / r_unlevered = 96,000 / 0.20 = 480,000.

Second, determine the base-case NPV assuming all-equity funding.
- The initial investment cost is $560,000.
- NPV_unlevered = Value_unlevered - Initial_investment = 480,000 - 560,000 = -80,000.
- This is the NPV contribution of the project when financed with all equity.

Third, add the present value of financing side effects, i.e., the tax shield from debt.
- The firm finances with $280,000 of perpetual debt at 10% interest, with the remainder funded by equity.
- The tax shield from debt is T_c × D, and under a perpetual debt assumption its PV is simply 0.40 × 280,000 = 112,000.
- This tax shield is an APV financing adjustment that increases the overall value.

Finally, combine the components to obtain the APV (NPV of the levered project):
- APV = NPV_unlevered + PV(tax shield) = (-80,000) + 112,000 = 32,000.

Thus, the levered project’s NPV under the APV method equals $32,000.

Note: The calculation hinges on two standard APV ingredients: (1) the all-equity NPV of the project (unlevered NPV) and (2) the PV of the tax shield from debt financing. The numbers align with these principles, yielding 32,000 as the net effect when combining them.

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