Digital Organics (DO) has the opportunity to invest $1 million now ( t = 0) and expects
Question:
Digital Organics (DO) has the opportunity to invest $1 million now ( t = 0) and expects after-tax returns of $600,000 in t = 1 and $700,000 in t = 2. The project will last for two years only. The appropriate cost of capital is 12% with all-equity financing, the borrowing rate is 8%, and DO will borrow $300,000 against the project. This debt must be repaid in two equal installments. Assume debt tax shields have a net value of $.30 per dollar of interest paid. Calculate the project’s APV using the procedure followed in Table 20.2 .
TABLE 20.2
APV valuation of Rio Corporation ($ millions).
| Latest |
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| year | Forecast
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| 0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 |
Free cash flow | 2.5 | 3.5 | 3.2 | 3.4 | 5.9 | 6.1 | 6.0 | 6.8 |
PV Free cash flow, years 1-6 | 19.7 |
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PV Horizon value | 64.6 |
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| (Horizon value in year 6) |
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| 113.4 |
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Base-Case PV of company | 84.3 |
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Debt | 51.0 | 50.0 | 49.0 | 48.0 | 47.0 | 46.0 | 45.0 |
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Interest |
| 3.06 | 3.00 | 2.94 | 2.88 | 2.82 | 2.76 |
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Interest tax shield |
| 1.07 | 1.05 | 1.03 | 1.01 | 0.99 | 0.97 |
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PV Interest tax shields | 5.0 |
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APV | 89.3 |
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Tax rate, % | 35.0 |
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Opportunity cost of capital, % | 9.84 |
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WACC, % (to discount horizon value to year 6) | 9.0 |
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Long-term growth forecast, % | 3.0 |
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Interest rate, % (years 1-6) | 6.0 |
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After-tax debt service |
| 2.99 | 2.95 | 2.91 | 2.87 | 2.83 | 2.79 |
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Principles of Corporate Finance
ISBN: 978-0072869460
7th edition
Authors: Richard A. Brealey, Stewart C. Myers