Question

Your firm which is headquartered in US is considering a 5-year international project, an addition of new product line to your existing product lines in Europe. The new product line would require a purchase of new equipment with a price of €600,000. The equipment will be depreciated entirely to €0 using straight-line method for 5 years.

The new product line is expected to generate €760,000 for year 1 and to increase its sales at a growth rate of 3% for next 4 years. Production costs (excluding depreciation) are estimated at €500,000 for year 1 and will also increase by 3% per year. Selling and administration expenses will remain at € 90,000 per year. Net working capitals (NWC) is projected to remain at 10% of projected sale of each year and will be financed through operating cash flow at the end of each year. Any remaining NWC will be fully recovered in cash at the sale of the equipment at the end of fifth year.

To finance this project (€600,000), you plan to issue 5-year annual euro-denominated bonds at par in Europe. According to your financial advisor, you can raise up to €300,000 by issuing 5-year annual 12% coupon bonds at par. However, you need to issue 5-year annual 14% coupon bonds at par for additional capitals above €300,000.

Below is the information you will use to estimate the cost of capitals. Your target capital structure depends on whether you will issue new equities in Europe or US. You should choose only one equity market (US or Europe) to issue new equities.

Equity Market	US	Europe
Equity Risk Premium	6%	7%
Risk free rate	4%	4%
Beta	0.9	1.0
Target capital structure (Debt/(Debt+Equity)	0.5	0.6

The project will pay a 40% tax rate. The current exchange rate between USD and Euro is $1/€ and remains constant. You assume that EBT (Earing Before Tax) is the same as taxable income.

If you choose to issue new equities in Europe, you are expected to pay a dividend of €4 per share in first year and the dividend will increase at a rate 3% per year afterwards. Calculate total amount of debts you need to issue in order to meet your target capital structure. Calculate the number, not amount of equities(stocks) you need to issue (Use Gordon constant growth model) Calculate after-tax cost of debts and cost of capitals.

Answer 1

Hi All,

A D F 1 2 Assuming to issue new debt and equity in US Exchange rate between US & Euros is 1:1 >Given 4 (a) New debt that needs to be issued: Debt/(Total equity) = Total equity 5 6 0.5 >Amount needed to finance the project, GIVEN -C7 C6 7 600000 8 New debt that needs to be issued 300000 9 Thus. 10 Debt 11 300000 -C8 300000 12 Equity -C7-C11 13 14 Tax rate 40% Given Pre tax cost of debt 15 12% >Given C15*(1-C14) 16 After tax cost of debt 7,2% 17 Using CAPM Cost of Equity,Ke-RFR+ (Beta *Equity Risk Premium) 18 19 20 4 %+ ( 0.9. 6 % ) Cost of equity 21 9.4% 22 WACC (Wt.debt*kd)+(Wt. Equity*ke) 23 8.3% 24 25 26 27 28 T

Please find below a screenshot of an excel which shows the working on how to solve for the total debt and cost of capital.

Hope you find this helpful. Please do give a thumbs up if you do! Thank you and all the best.