What are the different methods to calculate NPV for a 12-year project evaluation by DIY Inc.?
Calculating NPV for a 12-Year Project
DIY Inc. is evaluating a 12-year project that requires a machine costing $125,000 with a CCA rate of 25%. The project generates $42,500 annual before-tax cash flow for 12 years. The machine has a salvage value of $8,000 at year 12. The cost of debt is 6%, and the tax rate is 30%. In this scenario, DIY Inc. has three methods to calculate the Net Present Value (NPV) of the project:
a) Using the Weighted Average Cost of Capital (WACC) Method:
- Calculate the NPV by discounting the annual cash flows using the company's WACC of 10% and subtracting the initial investment.
- Formula: NPV = -Initial Investment + Σ(Cash Flow / (1 + WACC)^t)
- Plugging in the values: Initial Investment = $125,000, Annual Cash Flow = $42,500
- Calculate NPV for t = 1 to 12 using the given WACC of 10%.
b) Using the Flow-To-Equity (FTE) Method:
- Calculate the cost of equity using the formula: Cost of Equity = Cost of Debt * (1 - Tax Rate)
- Calculate the NPV by discounting the cash flows using the cost of equity derived from the previous step.
- Given values: Cost of Equity = 12.5%, Cost of Debt = 6%
- Calculate the NPV with the FTE method.
c) Using the Adjusted Present Value (APV) Method:
- Calculate the cost of unlevered equity using the formula: Cost of Unlevered Equity = WACC - (Cost of Debt * (1 - Tax Rate) * (Debt / Equity))
- Discount the cash flows using the cost of unlevered equity and add the present value of tax shields from debt financing.
- Given values: Cost of Unlevered Equity = 10.5%, Cost of Debt = 6%, Flotation Cost = 3%
- Calculate the NPV with the APV method considering the impact of debt financing.
The detailed calculations for each method will require additional information such as discount factors and tax shield value of debt. These methods allow DIY Inc. to evaluate the project's profitability and make informed investment decisions.