Q1

0

-200

FCF

a

3

50

4

50

5

50

i

ii

iii

iv

D

maturity

coupon

rA

NPVU

PV(tax shield)

NPV

50

5

1%

i

ii

iii

iv

50

0%

million

i

ii

D

int. rate

PV(tax shield)

PV(debt financing)

0

1

2

3

4

5

0

1

2

3

4

5

c

wE

betaE

2

50

30%

0.0

1%

4%

20%

b

d

1

50

wD

betaD

rf

rM-rf

T

rD

rE

WACC

NPV

70%

1.2

b. The firm is reconsidering its use of the WACC approach. In fact, it now believes the APV approach is more applicable because the capital structure weights will vary over time. However, the data above is still applicable for calculating the required return on the assets (using MM Prop. II with taxes from Handout 4.2). The actual debt structure will consist of an issuance of $50 million of risk-free, 1% annual coupon, 5-year debt at time 0, with all of the principal repaid at time 5.

i. What is the required return on the assets? (2 points)

ii. What is the NPV of the project with no leverage? (1 points)

iii. What is the present value of the tax shield? (2 points)

iv. What is the NPV of the project (using the APV approach)? (2 points)

million

million

years

c. The firm has just realized that it is eligible for an economic development debt subsidy. Specifically, instead of issuing risk-free debt, the firm will be provided with a 5-year, interest-free loan for $50 million.

i. What is the present value of the tax shield? (1 point)

ii. What is the total NPV associated with the subsidized debt financing? (2 points)

million

million

million

d. For the $50 million of 1%, 5-year debt in part b, what is the expected, after-tax, free cash flow to equity? For the $50 million of 0%, 5-year subsidized debt in part c, what is the expected, after-tax, free cash flow to equity? (1 point for each cash flow)

1% debt

FCFE

0% debt

FCFE

1. The table below gives the expected, after-tax, unlevered free cash flows (FCF) for a project under consideration (in $mill.).

a. The firm is going to finance this project with 30% risk-free debt, and 70% equity, with a beta of 1.2. The risk-free rate is 1% and the market risk premium is 4%. The corporate tax rate is 20%.

i. What is the before-tax cost of debt? (1 point)

ii. What is the cost of equity? (1 point)

iii. What is the after-tax WACC? (2 points)

iv. What is the NPV of the project in $mill. (using the WACC approach)? (2 points)

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