BFF5956 CORPORATE FINANCING DECISIONS Week 04
Hello, dear friend, you can consult us at any time if you have any questions, add WeChat: daixieit
BFF5956 CORPORATE FINANCING DECISIONS
Week 04 Tutorial Solutions – Capital Budgeting and Valuation with Leverage
Question 1
Suppose Caterpillar, Inc., has 666 million shares outstanding with a share price of $73.09 and $24.41 billion in debt. If in three years, Caterpillar has 709 million shares outstanding trading for $86.62 per share, how much debt will Caterpillar have if it maintains a constant debt- equity ratio?
Suggested solution
E = 666 million × $73.09 = $48.678 billion
D = $24.41 billion
D/E = 24.41/48.678 = 0.501.
In three years:
E = 709 million × $86.62 = $61.41 billion.
Constant D/E implies D = 61.41 × 0.501 = $30.766 billion.
Question 2
Suppose Goodyear Tire and Rubber Company is considering divesting one of its manufacturing plants. The plant is expected to generate free cash flows of $1.69 million per year, growing at a rate of 2.6% per year. Goodyear has an equity cost of capital of 8.5%, a debt cost of capital of 7.1%, a marginal corporate tax rate of 33%, and a debt-equity ratio of 2.4. 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?
Suggested solution
We can compute the levered value of the plant using the WACC method.
Goodyear’s WACC is:
1 2.4
= 1 + 2.4 × 8.5% + 1 + 2.4 × 7. 1% × (1 − 0.33) = 0.025 + 0.034 = 0.059
= 5.9%.
Therefore, = 1.69 = $51.21
A divestiture would be profitable if Goodyear received more than $51.21 million after tax.
Question 3
You are a consultant who has been hired to evaluate a new product line for Markum Enterprises. The upfront investment required to launch the product is $6 million. The product will generate free cash flow of $700,000 the first year, and this free cash flow is expected to grow at a rate of 6% per year. Markum has an equity cost of capital of 11.3%, a debt cost of capital of 6.28%, and a tax rate of 32%. Markum maintains a debt-equity ratio of 0.70.
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?
Suggested solution
a. = 1 × 11.3% + 0.7 × (1 − 0.32) × 6.28% = 6.647% + 1.758% =
8.405%
= 0.7 = $29. 106
= −6 + 29. 106 = $23. 106
b. Debt-to-Value ratio is: = 41. 176%
Therefore, Debt is: 41. 176% × $29. 106 = $11.985 .
c. Discounting at ru gives unlevered value.
= × 11.3% + × 6.28% = 6.647% + 2.586% = 9.233%
= 0.7 = $21.652
Tax shield value is therefore: 29. 106 – 21.652 = $7.454 .
Alternatively, initial debt is $11.985 million, for a tax shield in the first year of 11.985 × 6.28% × 0.32 = 0.241 .
Then, PV(interest tax shield) = = 7.454 .
Question 4
Your firm is considering a $120 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 8%. To fund the investment, your firm will take on $72 million in permanent debt.
a. Suppose the marginal corporate tax rate is 35%. Ignoring issuance costs, what is the NPV ofthe investment?
b. Suppose your firm will pay a 4% underwriting fee when issuing the debt. It will raise the remaining $48 million by issuing equity. In addition to the 7% underwriting fee for the equity issue, you believe that your firm’s current share price of $39 is $4 per share less than its true value. What is the NPV of the investment after accounting for these costs? (Assume all fees are on an after-tax basis.)
Suggested solution
a. With permanent debt the APV method is simplest.
= 20 = $250
( ℎ) = × = 35% × 72 = $25.2 = + ( ℎ)
= 250 + 25.2 = $275.2
Thus the NPV ofthe investment:
= 275.2 − 120 = $155.2
b. Assume all fees are on an after-tax basis.
Underwriting fee = 4% × 72 + 7% × 48 = $6.24
Underpricing cost = × 48 = $4.92
= 155.2 – 6.24 – 4.92 = $144.04
Question 5
You are on your way to an important budget meeting. In the elevator, you review the project valuation analysis you had your summer associate prepare for one of the projects to be discussed:
Looking over the spreadsheet, you realise that while all ofthe cash flow estimates are correct, your associate used the flow-to-equity valuation method and discounted the cash flows using the company’s equity cost of capital of 11%. While the project’s risk is similar to the firm’s, the project’s incremental leverage is very different from the company’s historical debt-equity ratio of 0.20: For this project, the company will instead borrow $80 million upfront and repay $20 million at the end of year 2, $20 million at the end of year 3, and $40 million at the end of year 4. Thus, the project’s equity cost of capital is likely to be higher than the firm’s, not constant over time—invalidating your associate’s calculation.
Clearly, the FTE approach is not the best way to analyse this project. Fortunately, you have your calculator with you, and with any luck you can use a better method before the meeting starts.
a. What is the present value of the interest tax shield associated with this project?
b. What are the free cash flows of the project?
c. What is the best estimate of the project’s value from the information given?
Suggested solution
a. First,
Interest Payment = Interest Rate (5%) × Prior period debt
From the tax calculation in the spreadsheet provided in the question, we can see that
the tax rate is = 40%.
Therefore,
Interest Tax shield = Interest Payment × Tax Rate (40%)
Because the tax shields are predetermined, we can discount them using the 5% debt cost of capital.
() = + + + = $4.67
0 Debt Interest at 5.0% Tax shield 40.0% PV 5.0% |
1 |
2 |
3 |
4 |
80 4 1.6 |
60 4 1.6 |
40 3 1.2 |
0 2 0.8 |
b. FCF = EBIT × (1 – Tc) + Depreciation – CapEx – NWC
0 1 2 3 4
EBIT
Taxes
10
-4
10
-4
10
-4
10
-4
Unlevered Net Income
Depreciation
6
25
6
25
6
25
6
25
Cap Ex -100
Additions to NWC -20 20
FCF -120 31 31 31 51
Alternatively:
FCF = FCFE + Int (1 – TC) – Net New Debt
Year 0 Year 1 Year 2 Year 3 Year 4
FCFE + After-tax Interest - Net New Debt |
-40
-80 |
28.6 2.4 0 |
8.6 2.4 20 |
9.2 1.8 20 |
9.8 1.2 40 |
FCF -120 31 31 31 51
c. With predetermined debt levels, the APV method is easiest.
Step 1: Determine rU. Assuming the company has maintained a historical D/E ratio of 0.20, we can approximate its unlevered cost of capital (see the formula in the lecture notes):
= × 11% + × 5% = 10%
Step 2: Compute
= + + + = $111.93
Step 3: Compute APV
APV = + PV(ITS) = 111.93 + 4.67 = $ million
Step 4: Compute NPV
= −100 − 20 + 116.6 = −$3.4
So, the project actually has negative value.
2022-03-29