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 i..(@9.5%). If the company finances the project entirely with equity, the firm's 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 A (all equity) Case B (all debt)

Earnings

Deprecitation

INterest

EBT

Taxes

Net income

Add back depreciation

Annual after tax cash flow

Time Cash flow A Cash flow B <--- Note that these should be the cash flows to the company (what they pay and what they receive)

0

1

2

3

4

Discount rate 13% 9.5%

NPV

Decision(accept/reject)

Are the answers different? If so, why? Should the project be undertaken?