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Chapter 14

Example 3

M Plc is looking to purchase a new piece of machinery. The company is
currently entirely equity financed, with a cost of equity of 12%.

The directors are keen to take advantage of debt finance for this piece of
machinery. The machinery will cost them $4million. The issue costs of the debt
finance will be $0.5millon and they intend to borrow the full amount using
irredeemable debt.

The directors of M Plc believe that the new piece of machinery will lead to
cash flow savings of $600,000 net of taxation for the foreseeable future.

The annual gross rate of interest required by the market on debt of similar risk
is 8%. The marginal tax rate is 25%.

Calculate the adjusted present value of the investment in $ million.

Give your answer in $ million to two decimal places.

Solution

Base case:

Year Cashflow ($) DF @ 12% PV ($)
0 –4,000,000 1 –4,000,000

1–∞ 600,000 1/0.12 5,000,000
1,000,000

Financing:

$ $

Interest 4,500,000 0.08 360,000
Tax saving/year 360,000 0.25 90,000

Tax saving in perpetuity 90,000 1/0.08 1,125,000
Issue costs –500,000

APV

1,000,000 + 1,125,000 -500,000 = 1,625,000

Answer = 1.63

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