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Your firm is evaluating a project which will generate an expected revenue of $15 million one year from today. The operating costs (which are variable) to produce the goods are expected to be $7 million dollars. The revenue and costs are expected to grow at a 3% rate, forever. The project will require investing $20M in machinery, which you must replace every 8 years. You will depreciate each machine down to a final book value of zero dollars over the first 4 years of its life. Your firm currently maintains a constant debt-equity ratio of 0.40. The firm’s equity beta is currently 1.4 and the debt is considered risk-free. The expected return of the market is 7% and the risk-free rate is 2%. The current tax rate is 20% but you reside in a country where interest payments to debt holders are not tax deductible.
a. What is the NPV of the project?
b. Now suppose you have changed your business operation and converted all variable costs to fixed costs. The fixed cost each year will be $7 million dollars. Also, in a surprise move, the government has changed the tax rate to 0%. What is the new NPV of the project?
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