BFF5956 CORPORATE FINANCING DECISIONS 4
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BFF5956 CORPORATE FINANCING DECISIONS
Week 04 Tutorial Questions – Capital Budgeting and Valuation with Leverage
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?
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?
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?
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 of the 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.)
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 ofthe projects to be discussed:
Looking over the spreadsheet, you realize that while all of the 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 analyze 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?
2022-06-23