ZuoTi.Pro
Question

You are considering a project with an initial investment of $20 million and annual cash flow...

You are considering a project with an initial investment of $20 million and annual cash flow (before interest and taxes) of $5,000,000. The project’s cash flow is expected to continue forever. The tax rate is 34%, the firm’s unlevered cost of equity is 18% and its after-tax cost of debt is 6.60%. The only side-effect from the use of debt that you are concerned about is related to the tax shield.

  1. If the project were to be financed with 100% equity, would you accept the project? Why or why not?
  2. If the project were to be financed with $10 million in perpetual debt and the rest with equity, use the APV method to help you decide whether to accept the project or not. Does your decision change from part (a)?
  3. Redo part (b) by using the FTE approach.
  4. Redo part (b) by using the WACC approach.
business   finance   
0 0
Add a comment Improve this question Transcribed image text
Next > < Previous
Sort answers by oldest

Homework Answers

Answer #1

a.

If the project to be financed by 100% equity

Initial Investment = $20 million

Annual Cash Flow = $5000000

Unlevered cost of Equity = 18%

Now Calculating Net Present Value (NPV)

NPV = -20000000 + 5000000/0.18 = $7777777.8

SInce net present Value is positive therfore we will accept the project.

b.

As per Adjusted Present Value Method (APV)

APV = Unlevered Firm Vale + Net effect of debt

Unlevered Firm Vale = NPV = $7777777.8

Net effect of debt = Tax Rate * Debt Amount = 0.34*10000000 = $3400000

APV = 7777777.8 + 3400000 =$11177777.8

Since APV is positive we will accept the project.

Yes, the decision will change as now the second option is preferred.

c.

Using Free Cash Flow method

Annual Cash Flow = $5 million

Interest Expense = 0.066*10 = $0.66 million

Net Cash Flow = $(5-0.66) million = $ 4.34 million

Tax Rate = 34%

Tax Amount = $1.4756 million

Free Cash Flow =( $5-$1.4756)million = $3.5244 million

NPV = (-20 + 3.5244/0.18 ) million= -$0.42 million

d.

Debt = $10 million

Equity = $10 million

WACC = (D/D+E)* After tax Cost of Debt + (E/D+E)* Cost of Equity

WACC = (10/20)*0.066 + (10/20)*0.18 = 12.3%

Now Calculating NPV

NPV = -$20 million + $5 million/0.123 = $20.65 million

0 0
Add a comment
Know the answer?
Add Answer to:
You are considering a project with an initial investment of $20 million and annual cash flow...
Your Answer:

Post as a guest

Your Name:

What's your source?

Earn Coins

Coins can be redeemed for fabulous gifts.

Log In

Sign Up

Not the answer you're looking for? Ask your own homework help question. Our experts will answer your question WITHIN MINUTES for Free.
Similar Homework Help Questions

  • Your firm’s market value balance sheet is given as follows: Market Value Balance Sheet Excess cash...

    Your firm’s market value balance sheet is given as follows: Market Value Balance Sheet Excess cash $30M Debt $230M Operating Assets $500M Equity $300M Asset Value $530M Debt + Equity $530M Assume that the you plan to keep the firm’s debt-to-equity ratio fixed. The firm’s corporate tax rate is 50%. The firm’s cost of debt is 10% and cost of equity is 20%. Now, suppose that you are considering a new project that will last for one year. According to...

  • 3. Consider Table 2 Table 2 Year 3 Year 4 Cash flow Year 2 Year 0 Year 1 Cash flovw Cash flow Cash flow 70 Cash flow Pr...

    3. Consider Table 2 Table 2 Year 3 Year 4 Cash flow Year 2 Year 0 Year 1 Cash flovw Cash flow Cash flow 70 Cash flow Project 80 70 30 -150 0.24 Interest Tax Shield 0.75 (a)Consider Table 2. Calculate the net present value of the project assuming it is all-equity financed. The required return on unlevered equity is 15%. (b)Consider Table 2. Assume for now that the project is financed using equal parts debt and equity. The cost...

  • 1. Billboard, Inc. is considering a new project costing $400 million. The project cost can be...

    1. Billboard, Inc. is considering a new project costing $400 million. The project cost can be depreciated on a straight-line over 20 years. Part of the cost of the project will be financed with a new bond issue. In order to finance a portion of new project, Billboard has sold for $93.54 million a twenty year, zero coupon bond with face value of $300 million. The issuance of debt will carry a one time cost at year 0 of $12.9...

  • Asgard Corp, is considering to purchase a smaller kingdom called Midgard. Asgard’s analysts project that the...

    Asgard Corp, is considering to purchase a smaller kingdom called Midgard. Asgard’s analysts project that the merger will result in the following incremental free cash flows, horizon values, and tax shields: Year 1 2 3 4 Free cash flow $2 $4 $4 $6 Unlevered horizon value $80 Tax shield $1 $2 $3 $4 Horizon value of tax shield $30 Assume that all cash flows occur at the end of the year and are in millions. Midgard is currently financed with...

  • 1. Chef wants to diversify with a new line of cooking utensils. The project costs $25...

    1. Chef wants to diversify with a new line of cooking utensils. The project costs $25 million and generates earnings before interest and taxes (EBIT) of $3,600,000 every year forever. The unlevered cost of capital is 11%. They will issue $15 million in debt with an interest rate of 8%. The debt is never repaid. The tax rate is 30%. The debt ratio (debt to value) is 60%. Use flow-to-equity (FTE) to find the project’s value. Unless stated otherwise, compounding...

  • NO COMPUTER SOFTWARE IS ALLOWED TO ANSWER THIS QUESTION Consider Table 2 3. Table 2 CF3 CF4 CF2 CF1 CFO Project 75 40 6...

    NO COMPUTER SOFTWARE IS ALLOWED TO ANSWER THIS QUESTION Consider Table 2 3. Table 2 CF3 CF4 CF2 CF1 CFO Project 75 40 60 110 110 (200) (200) (200) 75 40 60 75 40 60 110 0.80 0.24 2.00 3.60 Interest Tax Shield Additional information for all projects 15% Cost (required return) on unlevered equity (%) Cost of debt capital (%) Corporation tax rate (%) Financing of each project: Debt 10% 20% 100 100 Equit alculate the value of project...

  • Company J is considering a project with a 4-year lifespan. The initial cash flow estimate is...

    Company J is considering a project with a 4-year lifespan. The initial cash flow estimate is $125million in the first year increasing by $125million in each of the years 2 through 4. To begin the project, the company will need to invest $1billion dollars. Company J would like to cover the initial investment amount with existing internal resources and thereby not borrow. As such it remains an all-equity firm. The unlevered cost of its equity is 10%, similar to other...

  • You are considering an investment in a project that requires an initial outlay of $350,000 and...

    You are considering an investment in a project that requires an initial outlay of $350,000 and will produce after-tax cash flows of $50,000 per year for the next 10 years. Your firm uses 40 percent debt and 60 percent equity in its financing. The after-tax costs of debt and equity are 6% and 11%, respectively. a. What is the firm’s WACC? b. What is the project NPV? Should the project be accepted?

  • tial cost of this project is $10 million. The depreciation expense per year is $3 million....

    tial cost of this project is $10 million. The depreciation expense per year is $3 million. There will be no incremental increase in net working capital. Assume that this new project is of average risk for Omicron and that the firm wants to hold constant its debt to equity ratio. The corporate tax rate is 35%. Cost of debt is 6% and cost of equity is 12%. 1. Identify the most important criteria that the company must satisfy in order...

  • 8. (10) Teton wants to diversify with a new line of cooking utensils. The project costs...

    8. (10) Teton wants to diversify with a new line of cooking utensils. The project costs $24 million and generates earnings before interest and taxes (EBIT) of $3,600,000 every year forever. The unlevered cost of capital is 12%. Titan will issue $10 million in debt with an interest rate of 8%. Tax rate is 25%. Debt ratio (debt to value) is 40%. Calculate the value of the project using flow-to-equity (FTE).

ADVERTISEMENT
Free Homework Help App
Download From Google Play
Scan Your Homework
to Get Instant Free Answers
Need Online Homework Help?
Ask a Question
Get Answers For Free
Most questions answered within 3 hours.
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT