Problem: Valuation with APV/WACC
Suppose, Alex, approaches Tom with a plan to get in on the solar panel leasing business. Alex has identified an opportunity to acquire panels sufficient to power 25 homes. On average, Alex estimates that their enterprise will incur a cost of $1,000 for each installation. After that, each home installation will operate maintenance free and generate approximately $50 per month of revenue for 10 years. Assume that due to the rapid rate of technological depreciation, there will be neither demand nor salvage value for these solar panels at lease expiry.
Assume they will face a 40 percent tax rate. For tax purposes, they will be able to depreciate the total cost of equipment and installation over 5 years in a straight-¬line manner.
Their required return can be estimated from Solar Inc, a publicly traded pure-¬play solar panel leasing company with a beta of 2 and a debt-¬to-¬equity ratio of 1. They estimate that returns on a balanced market portfolio are 12 percent and the risk-¬free rate of borrowing is 4 percent.
I. Suppose, first, that Alex proposes they form an all-equity enterprise to invest in this opportunity. What is the maximum price they should pay for this inventory of panels? Hint: Use the APV/WACC method.
II. Suppose the seller is asking $50,000 for the total inventory of solar panels. Additionally, assume they can borrow $25,000 at 8 percent in the form of a five-year, interest-¬only loan, with the total principal retired via a balloon payment due in year 5. Does this investment make sense? Briefly explain the method used to arrive at that conclusion. Hint: Use either APV or WACC.
III. Finally, assume that after lengthy negotiations, the seller will not take less than $42,000 for the panels they need. Through continuing research, however, Alex discovers that one-in-ten firms that have gone into this business have gone bankrupt. What should be recommended now? (Hint: some assumptions regarding the magnitude of financial distress costs in the event of bankruptcy should be made.)