Question

A firm is planning to take a project that if funded entirely with equity has net after tax cash flows as indicated in the table below.

Year	Cash flow
0	-13000000
1	1500000
2	1500000
3	1500000
4	1500000
5	1500000
6	2000000
7	2000000
8	2000000
9	2000000
10	2000000
11	2500000
12	2500000
13	2500000
14	2500000
15	2500000
16	3000000
17	3000000
18	3000000
19	3000000
20	9000000

The firm estimates that the asset beta (i.e., when funded entirely with equity) for comparable projects is 1.2. The risk-free interest rate is 2.0% and the firm expects the market return over the next 20 years to average 12.0%. The project will operate as a corporation with a combined federal and state income tax rate of 26%.

The firm plans to fund 15% of the project with debt that makes annual interest payment at 4% for 20 years at which time the entire principal is due.

For all of the following, use annual cash flows and annual interest payments.

1a. Using the capital asset pricing model, determine the required return of the project if funded entirely with equity.

b. Calculate the net present value of the project if funded entirely with equity.

2a. Calculate the required return on leveraged equity.

c. Determine the weighted average cost of capital.

d. Using the WACC method, what is the net present value of the leveraged project?

3a. Calculate the amount of each annual interest payment on the loan.

b. Calculate the present value of the interest payments.

c. Determine the value of the tax shield of interest.

d. Using the APV method, what is the net present value of the leveraged project?

4a. Determine the initial investment by equity in the project and the annual cash flows to equity for the project in years 1-20.

b. Using the FTE method, what is the net present value of the leveraged project?

Answer 1

1a. Capital asset pricing model

CAPM = Risk free rate + Beta * Risk Premium

            = 2% + 1.2 * (12%-2%)

            = 2% + 1.2 * 10%

            = 2% + 12%

            = 14%

1b.