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 $.35 per dollar of interest paid.

Calculate the project’s APV.

Answer 1

To calculate the APV, discount the project's free cash flows at the cost of capital, and add the present value of the debt tax shields from the interest payments on borrowed funds.

Step-by-step explanation:

The student is asking how to calculate the Adjusted Present Value (APV) of a project undertaken by Digital Organics (DO) that requires an initial investment and yields returns over two years, considering both the cost of capital and the borrowing rate, including debt repayment and tax shields. To calculate the APV, the student must first compute the present value of the project's free cash flows, then add the present value of the financing effects, namely the tax shield benefits derived from interest payments on the debt.

The initial investment ($1.04 million) is made at time t = 0, so it is already in present value terms. The after-tax cash flows in years 1 and 2 need to be discounted at the cost of capital, which is 10%, to obtain their present values. The debt repayments at a 6% interest rate occur over two years; the student must also calculate the present value of the debt tax shields which add the value of $.35 per dollar of interest paid. All these values summed up will give the project's APV.