APV Co is a listed company with divisions which manufacture cars, motorbikes and cycles.

Over the last few years, APV Co has used a mixture of equity and debt finance for its investments. However, it is about to make a new investment of GHS150,000,000 in facilities to produce electric cars, which it proposes to finance solely by debt finance

Project information

APV Cos finance director has prepared estimates of the post-tax cash flows for the project, using a four-year time horizon, together with the realisable value at the end of four years:

Year Post-tax operating cash flows Realisable value

GHS GHS

1 28,500,000

2 36,700,000

3 44,400,000

4 50,900,000 45,000,000

Working capital of GHS6,000,000, not included in the estimates above and funded from retained earnings, will also be required immediately for the project, rising by the predicted rate of inflation for each year. Any remaining working capital will be released in full at the end of the project.

Predicted rates of inflation are as follows:

Year

1 5%

2 7%

3 3%

4 4%

The finance director has proposed the following finance package for the new investment:

GHS

Bank loan, repayable in equal annual instalments over the projects life, interest

payable at 7% per year 60,000,000

Subsidised loan from a government loan scheme over the projects life on which

interest is payable at 3% per year 90,000,000

150,000,000

Issue costs of 2% of gross proceeds will be payable on the subsidised loan. No issue costs will be payable on the bank loan. Issue costs are not allowable for tax.

Financial information

APV Co pays tax at an annual rate of 25% on profits one year in arrears.

APV Cos asset beta is currently estimated at 11. The current return on the market is estimated at 12%. The current risk-free rate is 7% per year.

APV Cos chairman has noted that all of the companys debt, including the new debt, will be repayable within three to five years. He is wondering whether APV Co needs to develop a longer term financing policy in broad terms and how flexible this policy should be.

Required:

(a) Calculate the adjusted present value (APV) for the project and conclude whether the project should be accepted or not. (15 marks)

(b) Discuss the factors which may determine the long-term finance policy which APV Cos board may adopt and the factors which may cause the policy to change.