Reference no: EM132467209

The Small Business Administration (SBA) is evaluating a firm's proposed project with a development period of three years and a benefit period of ten years. The required total investments at the end of years 1, 2, and 3 are $3,500, $5,000, and $4,000 respectively. Interest during the development period is capitalized. Add the interest charge each year to the capital outlay for that year to get the total outlay using the loan interest rate. Initial operating cost in year 4 is $350, and it remains constant in real terms over the remaining life of the project. The initial annual benefit is $2,800/year beginning at the end of year 4. However, this benefit is expected to grow at an annual rate of 2% beginning in year 5. The income tax rate is 20%. The discount rate for the firm is 12%. Ignore inflation for this problem.

(a) First undertake a "market analysis" in which you assess the benefits and costs of the project at market prices without any consideration of financing or taxes except that the interest during construction will be included in the capital charge to be applied in year 3. Calculate the NPV and IRR.

(b) Next, undertake a "private analysis" in which you assess the benefits and costs to the firm (i.e., considering project financing). Assume the SBA makes a loan for 80% of the total investment (with the 20% equity paid at the end of year 3), repayable at an 8% interest rate. The loan balance at the end of year 3 (which includes capitalized interest less equity paid) is serviced through equal installments over a seven-year repayment period. Calculate the after-finance NPV and IRR. (As a check, temporarily set the loan interest rate equal to the discount rate. Check that the market and private NPV are the same. If they are not, there is an error somewhere in your calculations. Check, the IRR values will not be the same. Why is that? Why is the after finance NPV and IRR higher than the project values when the standard 8% loan interest rate is used?)

(c) The total capital investment can be depreciated under US tax law over a period of 5 years starting in year 4 using the straight-line method. Salvage value is zero. Undertake a second "private analysis" in which you calculate the NPV and IRR for the cash flows after finance and taxes. If there are negative taxes, assume that the firm has positive taxes elsewhere to offset the negative taxes so that you can leave them as negative taxes. Under US tax law, depreciation and loan interest (but not loan principle payment) are tax deductible. Assume the interest capitalized in capital investment is not tax deductible. You will see that the after-tax NPV is lower than after finance, but IRR is higher. Why? How would you evaluate this project?

You may use excel for calculations.