Question

6:27 < Back Project 3.docx Please do all calculations in excel. Make sure to label your answers clearly and completely. Problem 1: Each question is worth 15 points You are considering investing in a project that costs $55,000,000 and are evaluating which capital structure is most beneficial to shareholders. Currently financed only with equity, the company currently has a beta of.8. If the company borrows money for the project, the cost of borrowing will be as follows: Total Debi Cost of debt $10,000,000 5% $15,000,000 5.25% $25,000,000 6 The expected market return is 10% and the risk free rate is 2%. The corporate tax rate is 30%. Part of the project will be funded by selling a 5 year asset that was purchased 4 years ago for $8,000,000. If kept in operation, the old asset would produce EBDITA of $1,000,000 next year and likely be non-productive thereafter. The new asset is projected to produce EBIDTA at the at a constant rate of $12,000,000 per year for 6 years. The project uses assets with a 5 year depreciable life and have no salvage value after 6 years. 1. What return should shareholder expect at each capital structure based on CAPM? 2. What are the incremental cash-flows of the proposed project? 3. What is the appropriate discount rate for each capital structure? 4. How much value is created for shareholders using cach of the proposed capital structures? 5. Based on your calculations, which capital structure produces the best return for shareholders based on the risk(s) taken? Project 2 Each question is worth 8.33 points You enter into a contract with Taylor county to pave several miles of roads in the coming years. In order to meet DOT standarde met he t worth nf in The Dashboard Calendar To Do Notifications inbox

Answer 1

Answer:

1. The return which shareholder expect at each capital structure based on CAPM should be :

= R_f + Beta ( R_m - R_f) = 2% + 0.8 ( 10% - 2% ) = 8.4%

Here,

R_f = Risk free rate of return

R_m = Market Return

Beta = Beta

Return as per CAPM be 8.4%

2. Incremental Cash flows of the proposed project be :

There are Two Capital Structures

1. Borrowed from Market $ 5000000 and remaining financed with equity of $ 5000000

2. Total financed with Equity

There are two options :

Option 1 : To sale the old Asset and borrow the remaining amount of investment in project.

Option 2 : To hold the Asset and Borrow the remaining amount of investment in project.

2 Incremental Cash flows at Proposed Project Option 1: To sale the old Asset and borrow the remaining amount of investment in project. Option 2: To hold the Asset and Borrow the remaining amount of investment in project. Incremental Cash Flows at Proposed Project Option 1 : To sale the old Asset and borrow the remaining amount of Option 2: To hold the Asset and Borrow the remaining amount of Particulars investment in project. investment in project. When Funds borrowed When Financed with Equity When Funds borrowed When Financed with Equity Cash Flow for 1 st Year Cash flow from Old Asset 1000000 1000000 Cash flow from New Asset 120000001 12000000 120000001 120000001 12000000 13000000 12000000 13000000 Less: Depreciation 8000000/5 -1600000 8000000/5 -1600000 8000000/5 -1600000 8000000/5 -1600000 Interest on Borrowings $25,000,000 25000000 x 6% -1500000 0 25000000 x 6% -1500000 $15,000,000 15000000 x 5.25% -787500 0 15000000 x 5.259 -787500 $10,000,000 10000000 x 5% -500000 0 10000000 x 5% -500000 10400000 -3120000 480000 11400000 -3420000 Earnings After Depreciation and Interest Less : Tax at 30% Add: Tax shield on Depreciation Add: Tax shield on Interest Earnings After Depreciation and Interest and Tax 7612500 -2283750 480000 836250 8612500 -2583750 480000 836250 6645000 7760000 7345000 7980000

2 Incremental Cash flows at Proposed Project Option 1 : To sale the old Asset and borrow the remaining amount of investment in project. Option 2: To hold the Asset and Borrow the remaining amount of investment in project. Incremental Cash Flows at Proposed Project Particulars Cash Flow from 2 nd Year Option 1 : To sale the old Asset and borrow the remaining amount of investment in project. 12000000 12000000 12000000 12000000 Option 2: To hold the Asset and Borrow the remaining amount of investment in project. 12000000 12000000 12000000 12000000 8000000/5 -1600000 8000000/5 -1600000 -1600000 8000000/5 -1600000 Less: Depreciation 8000000/5 Interest on Borrowings $25,000,000 25000000 x 6% $15,000,000 15000000 x 5.25% $10,000,000 10000000 x 5% -1500000 -787500 -500000 -1500000 -787500 -500000 0 25000000 x 6% 0 15000000 x 5.259 10000000 x 5% 10400000 -3120000 480000 10400000 -3120000 Earnings After Depreciation and Interest Less : Tax at 30% Add: Tax shield on Depreciation Add: Tax shield on Interest Earnings After Depreciation and Interest and Tax 7612500 -2283750 480000 836250 7612500 -2283750 480000 836250 7760000 7280000 6645000 6645000 Incremental Cash Flows From Proposed project be In first Year 6645000-6645000 From 2nd Year 6645000-6645000 0 7760000-664500 0 7760000-664500 1115000 7345000-664500 1115000 6645000-664500 700000 7980000-728000 0 7760000-664500 700000 1115000

3. Appropriate discount rate of each capital Structure be rate calculated by using CAPM model as in answer 1 i.e 8.4%

4. Value created for shareholders using each of the proposed capital structure be :

Option 1: To sale the old Asset and borrow the remaining amount of investment in project. When Funds borrowed When Financed with Equity Discount Discounted Discount Year Particulars Cash Flow factor at 84% Cash Flow Cash Flow factor at 84% Discounted Cash Flow O Investment in project -55000000 -55000000-55000000 -55000000 O Sale Proceeds from Asset 1600000 1600000 1600000 1600000 Earnings After Depreciation Year 1 to and Interest and Tax 6645000 4.5673 30349708.5 7760000 4.5673 35442248 Net Present Value -23050291.5 -17957752 Option 2: To hold the Asset and Borrow the remaining amount of investment in project. When Funds borrowed When Financed with Equity Year Particulars o Investment in project Discount Discount Cash Flow factor at 84% Discounted Cash Cash Flow factor at 84% Discounted Cash Flow -55000000 -55000000-55000000 -550000001 O Sale Proceeds from Asset Earnings After Depreciation 1 and Interest and Tax 7345000 0.9225 6775762.5 7980000 0.9225 7361550 Earnings After Depreciation and Interest and Tax 6645000 3.6448 24219696 7280000 3.6448 26534144 Net Present Value -24004541.5 -21104306

5. Based on the calculations capital structure produces the best return on shareholders based on the risk taken be with option as  Whole finance with equity and sold the old asset