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Behavioral Finance - Computing APV for AutoNation

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AutoNation is contemplating a project that requires a $350 million intial outlay and features an NPV of $48 million. The firm is all-equity financed and has $150 million in cash that it plans to invest in the project. AutoNation's current market value of equity is $3.4 billion. AutoNation could raise $200 million of external financing by using new debt at 5% or issuing new equity. If the firm issues new equity the new shareholders would hold 5% of the firm whose total value including the new project is estimated to be worth ~ $4 billion. AutoNation feels their firm is overvalued in the market. They have concluded that the minimum which new shareholders should demand for the $200 million is 5.3% of the firm. In this respect the managers estimate the intrinsic value to be $3.8 billion if they adopt the project. Corporate tax rate is 35%; financial distress is low enough to be ignored; floatation costs are 0.

COMPARE the APV of the project if financed with debt versus the APV if financed with equity. Which is the better way to finance the project.

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Solution Summary

The solution compares APV of the project if financed with debt versus the APV if financed with equity. It is determined which option is better to finance the project.

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