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Adam Smith Inc. has a target debt-equity ratio of 2/3. Its cost of equity is 16% and it can borrow at an interest rate of 9% (before tax). The firm is considering an expansion of its existing business which will cost $17 million today and generate pre-tax operating cash flows of $6 million per year at the end of each of the next 8 years. The corporate tax rate is 35%.
Problem (a) Use the weighted average cost of capital approach to determine the net present value of the proposed expansion.
Problem (b) Suppose that Adam Smith Inc. uses a different financing strategy. It borrows the same amount initially as in part (a) above, but uses a loan that stays constant until the end of the project and will be repaid after 8 years. The interest rate on this loan is the same as that in part (a). If the firm uses the APV approach to calculate the net present value of the project, would it be higher or lower than that found in part (a)? Explain why. (Do not do any calculations, just provide a short intuitive explanation.)
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