Sampa Video: essay:

Question 1] What are the annual projected free cash flows? What is the NPV of the project assuming the firm was entirely equity financed? What discount rate is appropriate?

Annual Projected Free Cash Flows
Detailed annual projected free cash flows calculations are summarized in APPENDIX I.
Free Cash Flows (FCF) are calculated using following relationship.
FCF = EBIAT + Depreciation - Investments

In brief, annual projected free cash flows are as following.

NPV of Project 100% Equity Financed
NPV is calculated by discounting annual FCFs to present (end of fiscal/calendar 2001). Here unlevered required rate of return (cost of capital) is used as a discount factor.

NPV of Project in $K is = $1,228K @ Discount Factor 15.8%

Appropriate Discount Rate
We think the appropriate discount rate should be equal to unlevered required rate of return (cost of capital) for the project.

Procedure
1. Asset Beta of Twin = 1.50 … Given, Case Material  Project Asset Beta = 1.50
2. Market Risk Premium = 7.2% …Given, Case Material
3. Risk-free Rate = 5.0% …Given, Case Material
4. Using CAPM, Discount Rate = 5.0% + 1.50X7.2% = 15.8%

Appropriate Discount Rate = Cost of Capital = 15.8%

Question 2] Value the project using the Adjusted Present Value (APV) approach, assuming the firm raises $750,000 of debt to fund the project and keeps the level of debt constant in perpetuity.

Detailed calculations for project’s NPV using APV approach and assuming $750K of debt in perpetuity is summarized in APPENDIX II.

Procedure, Two-part Solution
1. Part I – NPV of Project assuming 100% Equity Financed. This NPV is same as in APPENDIX I using discount factor = 15.8%
2. Part II – NPV of Interest Tax Shield (ITS). ITS CFs are calculated using ITS = Debt X Cost of Debt X Tax Rate. Since debt levels are held constant in perpetuity,