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Base case net present value is approximately ($5·09 million) and on this basis, the investment should be rejected.
Workings:
1) Working capital
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2) Discount rate
Using asset beta
All-equity financed discount rate
= 4% + (11% - 4%) 1·14 = 12%
3) Issue costs
$80 million/0·97 = $82,474,227
Issue costs
= 3% x $82,474,227 = $2,474,227
There will be no issue costs for the bank loan.
4) Tax shield on subsidised loan
Use PV of an annuity (PVA) years 1 to 4 at 8% (normal borrowing rate)
$80m x 0·031 x 30% x 3·312 = $2,464,128
Note to markers
Full credit should be given if tax shield is discounted at the government interest rate of 3·1% rather than the normal borrowing rate of 8%.
5) Tax shield on bank loan
Annual repayment
= ($70m/PVA 8% Yr 1 - 4)
= ($70m/3·312) = $21,135,266
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6) Subsidy benefit
Benefit
= $80m x (0·08 - 0·031) x 70% x 3·312
= $9,088,128
7) Financing side effects
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Financing the project in this way would add around $12·82 million to the value of the project.
The adjusted present value of the project is around $7·73 million and so the project should be accepted. Sensitivity analysis should be undertaken on all the significant variables. Further analysis may be needed, particularly of the assumptions which lie behind the post-tax cash flows, such as sales and the tax rate. The realisable value of $45 million may be questionable.
On the other hand, the time horizon of four years seems low and analysis should be done of potential cash flows beyond that time.
