Gemini, Inc., an all-equity firm, is considering a $1.7 million investment that will be depreciated according to the straight-line method over its four-year life. The project is expected to generate earnings before taxes and depreciation of $595,000 per year for four years. The investment will not change the risk level of the firm. The company can obtain a four-year, 9.5 percent loan to finance the project from a local bank. They will receive the total amount needed for investment ($1.7 million at time 0) and all principal will be repaid in one balloon payment at the end of the fourth year (similar to a bond). Every year the company would need to pay interest (@9.5%). If the company finances the project entirely with equity, the firms cost of capital would be 13 percent. The corporate tax rate is 30 percent. Calculate the cash flows and NPV for the two cases: a) If the company finances the project entirely with equity, and b) if the company finances the project entirely with the bank loan. Are the answers different? If so, why? Should the project be undertaken? (Hint: In the first case you need to discount your cash flows at 13% and in the second case with 9.5% when you calculate NPV).

Case B All debt financing Case A All equity financing Earnings Depreciation Interest EBT Taxes Net Income Add back Depreciation Annual After-tax Cash Flow 595,000.00 425,000.00 161,500.00 Time Cash Flow Cash Flow 4 Discount rate NPV Decision (accept or reject) Do not accept Accept