Finance Essay examples
Normal NPV calculation:
where, in a simple situation:
Using debt for financing has a tax advantage in that interest payments are tax deductible. This tax deductibility is a source of value for the firm. In the normal NPV calculation, this additional value is accounted for in the WACC.
However, in many cases the capital structure of the project may change over time. In other cases the tax rate faced by the firm may be expected to change over time (as firm goes from loss to profit, or special tax subsidies expire etc.). In other cases, the firm may be able to obtain subsidized financing from a government agency for the project. In all of these circumstances, these types of things mean that …show more content…
The problem with this example is that the capital structure of the project actually changes in three years when the debt must be paid off. This means that the WACC will actually change at that time. Calculating the NPV by discounting the cashflows at the WACC can become complicated. APV approaches the problem this way:
NPV of project if all equity financed =
Note that if all equity financed, the project is not a good one.
The benefit of debt financing is now calculated as the NPV of the loan. Note that the loan gives a cash inflow of $22,500,000 today, followed by 3 annual interest payments of $2,250,000(1-0.3) = $1,575,000 on an after tax basis, and then a cash outflow of $22,500,000 to pay off the loan. The appropriate rate at which to discount is the loan rate as this reflects the risk of the loan. The NPV of the loan is therefore:
NPV of financing = [pic]
So, financing with debt creates an extra $1,678,625 in value because of the tax deduction associated with the interest (note that if there were no tax you could do the calculation and the NPV of the loan would always be zero; the source of the value in this case is the tax shield generated by debt).
In total the value of the project is:
APV = -1,084,490 +1,678,625 = $594,135
The project is a worthwhile investment after incorporating the value of the financing arrangements.