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BFC3140 Corporate Finance 2

Week 04 Tutorial Answers - Capital Structure: Leverage and Capital Budgeting (Chapter 18)

18-2. Suppose Caterpillar, Inc., has 653 million shares outstanding with a share price of $75.14, and $25.99

billion in debt. If in three years, Caterpillar has 710 million shares outstanding trading for $86.58 per share, how much debt will Caterpillar have if it maintains a constant debt-equity ratio?

E = 653 million × $75. 14 = $49.066 billion, D = $25.99 billion, D/E = 25.99/49.066 = 0.5297. E = 710 million × $86.58 = $61.472 billion, D = ?

= = 0.5297

D = 0.5297 × 61.472 = $32.56 billion

18-5. Suppose Goodyear Tire and Rubber Company is considering divesting one of its manufacturing

plants. The plant is expected to generate free cash flows of $1.5 million per year, growing at a rate of 2.5% per year. Goodyear has an equity cost of capital of 8.5%, a debt cost of capital of 7%, a marginal corporate tax rate of 35%, and a debt-equity ratio of 2.6. If the plant has average risk and Goodyear plans to maintain a constant debt-equity ratio, what after-tax amount must it receive for the plant for the divestiture to be profitable?

We can compute the levered value of the plant using the WACC method. Goodyear’s WACC is

1 2.6

rwacc = 1+ 2.6 8.5% + 1+ 2.6 7%(1− 0.35) = 5.65%.

Therefore, VL = = $47.6 million

A divestiture would be profitable if Goodyear received more than $47.6 million after tax.

18-9. You are a consultant who was hired to evaluate a new product line for Markum Enterprises. The

upfront investment required to launch the product line is $13 million. The product will generate free cash flow of $760,000 the first year, and this free cash flow is expected to grow at a rate of 5% per year. Markum has an equity cost of capital of 10.7%, a debt cost of capital of 4.45%, and a tax rate of 38%. Markum maintains a debt-equity ratio of 0.80.

a. What is the NPV of the new product line (including any tax shields from leverage)?

b. How much debt will Markum initially take on as a result of launching this product line?

c. How much of the product line’s value is attributable to the present value of interest tax shields?

a. Step 1: Calculate the WACC.

TWACC = (10.7%) + (4.45%)(1 − 0.38) = 5.944% + 1.226% = 7. 17%

VL = = $35.02 million

NPV = $35.02 million - $13 million = $22.02 million

b. Debt − equity Tatio = = 0.4444 = 44.44%

Therefore, debt is 44.44% x $35.02 million =$15.56 million

c. Discounting at TU gives the unlevered value.

TU = (10.7%) + (4.45%) = 7.92%

VU = = $26.03 million

Tax shield value is therefore $35.02 million - $26.03 million = $8.99 million

18-22.

Your firm is considering a $150 million investment to launch a new product line. The project is expected to generate a free cash flow of $20 million per year, and its unlevered cost of capital is 10%. To fund the investment, your firm will take on $100 million in permanent debt.

a. Suppose the marginal corporate tax rate is 20%. Ignoring issuance costs, what is the NPV of the investment?

b. Suppose your firm will pay a 2% underwriting fee when issuing the debt. It will raise the remaining $50 million by issuing equity. In addition to the 5% underwriting fee for the equity issue, you believe that your firm’s current share price of $40 is $5 per share less than its true value. What is the NPV of the investment including any tax benefits of leverage? (Assume all fees are on an after-tax basis.)

a. With permanent debt the APV method is simplest. NPV(unlevered) = - 150 + 20 / 0.10 = $50 million. PV(ITS) = τc × D = 20% × 100 = $20 million. Thus, the NPV with leverage is APV = NPV + PV(ITS) = 50 + 20 = $70 million.