Question

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 million. The issuance cost can not be depreciated or used to offset taxes. The project generates EBIT with an expected value of $40 million for each of the next twenty years, commencing one year after the start of the project. CFO believes that the debt obligation will be fulfilled with probability ONE, implying that the interest expense deductions associated with the tax-shield on the new debt have a zero covariance with the return on the market. The cash flows of the project do vary with the market, with the implied unlevered asset beta equal to 1.5. The expected return on the market is 12% and the risk-free rate is 6%. The CFO believes that the government is likely to push for an increase in the corporate income tax rate from 16% up to 28%,

and ascribes a 75% chance that government will succeed in getting to pass the tax increase proposal. The CFO assumes that this event has zero covariance with the market portfolioís return and has no effect on the projects unlevered asset beta. He asks you to evaluate the project using APV. Billboard, Inc. must make its accept/reject decision on BEFORE outcome of the government tax debate is known.

(a) (5 points) Find the expected corporate tax rate

(b) (5 points) What are the expected annual after-tax Unlevered Cash Flows associated with the project?

(c) (5 points) What is the discounted value (PV) of the after-tax Unlevered Cash Flow stream?

(d) (5 points) Compute an amortization table for the bond.

(e) (5 points) What is the value of the Debt Tax Shield associated with this project?

(f) (5 point) What is the projectís APV? Should Billboard, Inc. invest into project?

Answer 1

a) The calculation of the expected corporate tax rate is as under:

Tax Rate Probability Wtd Tax Rate 28% 21% 16% 0.25 4% 0.75 25%

b) For arriving at the Unlevered Cash Flows, first we need to know the annual interest obligation. That turns out to be 6%, for the zero-coupon bonds in the problem above, either via excel or the Texas BA II Plus Calculator.

Then CF's are tabulated as under:

Tax 40 Based on YTM PBT 40 5.61 34.39 5.95 34.05 40 6.31 33.69 40 6.68 33.32 7.09 32.91 7.51 32.49 40 7.96 32.04 40 8.44 31.56 8.95 31.05 9.48 30.52 10.05 29.95 10.65 29.35 11.29 28.71 11.97 28.03 12.69 40 13.45 26.55 14.26 25.74 15.11 24.89 16.02 23.98 40 16.98 23.02 8.60 8.51 8.42 8.33 8.23 8.12 8.01 7.89 7.76 7.63 7.49 7.34 7.18 7.01 6.83 6.64 6.44 6.22 5.99 5.75 400/20 PAT + I(1-TR)+NCC PAT Dep CF's 25.79 20 50.00 25.54 20 50.00 25.27 20 50.00 24.99 20 50.00 24.69 20 50.00 24.37 20 50.00 24.03 50.00 23.67 20 50.00 23.29 50.00 22.89 20 50.00 22.46 50.00 22.01 20 50.00 21.53 50.00 21.02 20 50.00 20.48 50.00 19.91 20 50.00 19.31 50.00 18.67 50.00 17.98 50.00 17.26 20 50.00 20 40 27.31 20

c) For computing the PV of Cash Flows, we first need to compute WACC, which is as under. For Cost of Debt, post-tax cost of debt is taken, and for Cost of Equity, it is derived using CAPM. This translates to 4.5% and 15% respectively:

Wts 3.38% 4.50% 15% 0.75 0.25 3.75% 7.13%

Then, we need to discount the CF's using the WACC so obtained, as under:

CF's DF's PV 50.00 50.00 50.00 50.00 50.00 50.00 50.00 50.00 50.00 50.00 50.00 50.00 50.00 50.00 50.00 50.00 50.00 50.00 50.00 50.00 0.93 0.87 0.81 0.76 0.71 0.66 0.62 0.58 0.54 0.50 0.47 0.44 0.41 0.38 0.36 0.33 0.31 0.29 0.27 0.25 46.67 43.57 40.67 37.97 35.44 33.08 30.88 28.83 26.91 25.12 23.45 21.89 20.44 19.08 17.81 16.62 15.52 14.49 13.52 12.62 524.59

d) The amortisation table for the bond is as under:

Interest 6 Year 1.00 2.00 3.00 4.00 5.00 6.00 7.00 8.00 9.00 10.00 11.00 12.00 13.00 14.00 15.00 16.00 17.00 18.00 19.00 20.00 Op Bal 93.54 99.15 105.10 111.41 118.09 125.18 132.69 140.65 149.09 158.03 167.52 177.57 188.22 199.52 211.49 224.18 237.63 251.89 267.00 283.02 7.51 7.96 8.44 8.95 9.48 10.05 10.65 11.29 11.97 12.69 13.45 14.26 15.11 16.02 16.98 End Bal 99.15 105.10 111.41 118.09 125.18 132.69 140.65 149.09 158.03 167.52 177.57 188.22 199.52 211.49 224.18 237.63 251.89 267.00 283.02 300.00

You will observe, that by the 20th year, the Bond has reached its retirement value of $ 300 Million.

Answering only the first four sub-parts as per Guidelines.