Transaction cost of Debt and APV

Hi John,

Thanks for this. You are right. I read the requirements again and it did say to use APV. With regards to the wording of the issue cost please see below

The new issue will incur transaction costs of 2% of the issue value at the date of issue.
Required

Many Thanks

Carlos

Hi John,

This is the full question. Is there a way I could send you my solution to review for me please. I got a negative NPV and feel like I’ve missed something out.

Neptune is a listed company in the telecommunications business. You are a senior financial
management advisor employed by the company to review its capital investment appraisal procedures
and to provide advice on the acceptability of a significant new capital project – the Galileo.
The project is a domestic project entailing immediate capital expenditure of $800 million at 1 July
20X8 and with projected revenues over five years as follows:
30 June 30 June 30 June 30 June 30 June
Year ended 20X9 20Y0 20Y1 20Y2 20Y3
Revenue ($ million) 680.00 900.00 900.00 750.00 320.00
Direct costs are 60% of revenues and indirect, activity based costs are $140 million for the first year of
operations, growing at 5% per annum over the life of the project. In the first two years of operations,
acceptance of this project will mean that other work making a net contribution before indirect costs of
$150 million for each of the first two years will not be able to proceed. The capital expenditure of $800
million is to be paid immediately and the equipment will have a residual value after five years’
operation of $40 million. The company depreciates plant and equipment on a straight-line basis and,
in this case, the annual charge will be allocated to the project as a further indirect charge.
Preconstruction design and contracting costs incurred over the previous three years total $50 million
and will be charged to the project in the first year of operation.
The company pays tax at 30% on its taxable profits and can claim a 50% first year allowance on
qualifying capital expenditure followed by a writing down allowance of 40% applied on a reducing
balance basis. Given the timing of the company’s tax payments, tax credits and charges will be paid
or received twelve months after they arise. The company has sufficient other profits to absorb any
capital allowances derived from this project.
The company currently has $7,500 million of equity and $2,500 million of debt in issue quoted at
current market values. The current cost of its debt finance is $LIBOR plus 180 basis points. $LIBOR is
currently 5·40%, which is 40 basis points above the one month Treasury bill rate. The equity risk
premium is 3·5% and the company’s beta is 1·40. The company wishes to raise the additional finance
for this project by a new bond issue. Its advisors do not believe that this will alter the company’s bond
rating. The new issue will incur transaction costs of 2% of the issue value at the date of issue.
Required
Estimate the adjusted present value of the project resulting from the new investment and from the
refinancing proposal and justify the use of this technique.