The CFO of Northern Petroleum Plc is preparing a presentation to her

Question

The CFO of Northern Petroleum Plc is preparing a presentation to her

fellow directors to consider investment into a new project in Detriot that would cost $162.5m. To finance the project $42.7 million is available as a soft 3-year development loan offered at a rate of interest discounted by 3.62% from the rate Northern Petroleum would normally pay. $59.1 million would be funded by internally generated funds. The balance of funding would be borrowed via a 3-year term loan at a rate of 7.58%. Northern Petroleum has a pre-tax cost of capital of 9%. It also pays corporation tax at 18% and can claim writing down allowances at 30% in the first year and 20% thereafter on a reducing balance basis. It would generate pre-tax cash inflows of $64.15 million per year over the investment's 3-year life resulting in a $39.2 million residual value at the end of year 3. Required: (A)Calculate the Adjusted Present Value of the above investment and advise the Northern Petroleum CFO as to whether the investment should be accepted. (B) Having given your advice, the CFO of Northern Petroleum questions why you have used the APV method to evaluate the investment rather than the Net Present Value approach using the Weighted Average Cost of Capital as your discount rate. Explain the advantages of APV and disadvantages of WACC.

Answer 1

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