Question

Digital Organics (DO) has the opportunity to invest $1.04 million now (t=0) and expects after-tax returns of $640,000 in t=1 and $740,000 in t=2. The project will last for two years only. The appropriate cost of capital is 10% with all-equity financing, the borrowing rate is 6%, and DO will borrow $340,000 against the project. This debt must be repaid in two equal installments of $170,000 each. Assume debt tax shields have a net value of $0.35 per dollar of interest paid. Calculate the project's APV. (Enter your answer in dollars, not millions of dollars. Do not round intermediate calculations. Round your answer to the nearest whole number.)

Answer 1

To calculate the project's APV, we need to calculate the present value of the after-tax returns in each period, as well as the present value of the tax shields from the debt. The present value of the after-tax returns and tax shields should be summed to get the project's APV, which is $1,236,431.

Step-by-step explanation:

To calculate the project's APV, we need to calculate the present value of the after-tax returns in each period, as well as the present value of the tax shields from the debt. The after-tax returns of $640,000 in t=1 and $740,000 in t=2 should be discounted at the appropriate cost of capital, which is 10%. The debt tax shields of $0.35 per dollar of interest paid should also be discounted at the borrowing rate of 6%. The debt repayment of $340,000 should be subtracted from the present value of the tax shields. Finally, the present values of the after-tax returns and tax shields should be summed to get the project's APV.

Present value of after-tax returns:
PV(t=1) = $640,000 / (1 + 10%)1 = $581,818.18
PV(t=2) = $740,000 / (1 + 10%)2 = $607,438.02

Present value of tax shields:
PV(t=1) = $340,000 * 0.35 / (1 + 6%)1 = $111,760.62
PV(t=2) = $340,000 * 0.35 / (1 + 6%)2 = $105,415.04

Subtracting the debt repayment:
PV(t=2) = $105,415.04 - $170,000 = -$64,584.96

Summing the present values:
APV = $581,818.18 + $607,438.02 + $111,760.62 - $64,584.96 = $1,236,431