I need some help with something I can’t figure out.
Let’s say a company buys a piece of equipment that costs $100 to rent out for a period of 5 years. It purchases this equipment using money borrowed from a bank (i.e. 100% loan to value, no capital outlay from equity holders).
Let’s say this equipment produces $20 of Free Cash Flow To The Firm per year.
The cash flows schedule for Project NPV will look like this:
T0 = -100
T1 = 20
T2 = 20
T3 = 20
T4 = 20
T5 = 20
Now if I want to calculate the Equity NPV (taking into account the principal repayment on the loan), how would I calculate it because there’s no capital outlay from the equity holders. Let’s say principal repayment is $5 per year for simplicity.
The schedule will look like this:
T0 = ???
T2 = 15 (20 in free cash flow to firm - 5 principal repayment)
…
T5 = 15
Do I still use -100 as capital outlay to calculate Equity NPV??
Or do I use 0 as the outlay. In that case, my NPV is simply the PV of future cash flows.
CF1= 20 for 5 periods Calculate NPV with a discount rate. This is the firm value. Subtract MV of debt from NPV. This is the value of equity. As an example, using a 7% discount rate, the NPV is $82. Debt is $100. Equity value is -$18. You could tackle it in a different way as well. Do the NPV but use -100 as CF0. It’ll give you the same result.
This makes sense. The key is to have high enough cash flows such that your NPV becomes positive. This way equity holders get a free lunch. Interesting.