Advanced Corporate Finance Leonidas Rompolis

EXERCISES -5 (SOLUTIONS)

4. We make three adjustments to the balance sheet:

• Ignore deferred taxes; this is an accounting entry and represents neither a liability
nor a source of funds
• ‘Net out’ accounts payable against current assets
• Use the market value of equity (7.46 million x $46)
Now the right-hand side of the balance sheet (in thousands) is:
Short-term debt $75,600
Long-term debt 208,600
Shareholders’ equity 343,160
Total $627,360
The after-tax weighted-average cost of capital formula, with one element for each
source of funding, is:
DL D E
WACC = (1 − τc )rDL + (1 − τc )rDS S + rE
V V V
WACC = [0.06×(1 – 0.35)×(75,600/627,360)]+[0.08×(1 –0.35)×(208,600/627,360)]
+ [0.15×(343,160/627,360)]
= 0.004700 + 0.017290 + 0.082049 = 0.1040 = 10.40%

5. Assume that short-term debt is temporary. From Practice Question 4:

Long-term debt $208,600
Share holder equity 343,160
Total $551,760
Therefore:
D/V = $208,600/$551,760 = 0.378
E/V = $343,160/$551,760 = 0.622
Step 1:
r = rD (D/V) + rE (E/V) = (0.08 × 0.378) + (0.15 × 0.622) = 0.1235
Step 2:
rE = r + (r – rD) (D/E) = 0.1235 + (0.1235 – 0.08) × (0.403) = 0.1410
Step 3:
WACC = [rD × (1 – TC) × (D/V)] + [rE × (E/V)]
= (0.08 × 0.65 × 0.287) + (0.1410 × 0.713) = 0.1155 = 11.55%

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Advanced Corporate Finance Leonidas Rompolis

6. Base case NPV = –$1,000 + ($600/1.12) + ($700/1.122) = $93.75 or $93,750

The dept outstanding at the beginning of year 1 is $300,000 and at the beginning of
year 2 is $150,000. The interest paid the 1st year is 300,000 × 0.08 = $24,000 while
that paid the 2nd year is 150,000 × 0.08 = $12,000.
The interest tax shield is 24,000 × 0.3 = $7,200 for the 1st year and 12,000 × 0.3 =
$3,600 for the second year. The present values of these two tax shields are:
7.2
PV1 = = 6.67
1.08
3.6
PV2 = = 3.09
1.082

Therefore,
APV = $93.75 + $6.67 + $3.09 = 103.5 or $103,500

7. a. Base-case NPV = –$1,000,000 + ($85,000/0.10) = –$150,000

PV(tax shields) = 0.35 × $400,000 = $140,000
APV = –$150,000 + $140,000 = –$10,000

b. PV(tax shields, approximate) = (0.35 × 0.07 × $400,000)/0.10 = $98,000

APV = -$150,000 + $98,000 = –$52,000
The present value of the tax shield is higher when the debt is fixed and therefore
the tax shield is certain. When borrowing a constant proportion of the market
value of the project, the interest tax shields are as uncertain as the value of the
project, and therefore must be discounted at the project’s opportunity cost of
capital.

13. a. Assume that the expected future Treasury-bill rate is equal to the 20-year
Treasury bond rate (5.2%) less the average historical premium of Treasury bonds
over Treasury bills (1.8%), so that the risk-free rate (rf) is 3.4%. Also assume that
the market risk premium (rm – rf) is 8%. Then, using the CAPM, we find rE as
follows:
rE = rf + βA × [rm – rf] = 3.4% + (0.46 × 8%) = 7.08%
Market value of equity (E) is equal to: 324.5 × $40.59 = $13,171.5 so that:
V = $2,327 + $13,171.5 = $15,498.5
D/V = $2,327/$15,498.5 = 0.150

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Advanced Corporate Finance Leonidas Rompolis

E/V = $13,171.5/$15,498.5 = 0.850

WACC = (0.850 × 7.08%) + (0.150 × 0.65 × 7.0%) = 6.70%

b. The opportunity cost of capital is:

r = rD × (D/V) + rE × (E/V) = 7.0% × 0.150 + 7.08% × 0.850 = 7.07%

14.
Latest
year Forecast
0 1 2 3 4 5
1. Sales 40,123.0 36,351.0 30,155.0 28,345.0 29,982.0 30,450.0
2. Cost of Goods Sold 22,879.0 21,678.0 17,560.0 16,459.0 15,631.0 14,987.0
3. Other Costs 8,025.0 6,797.0 5,078.0 4,678.0 4,987.0 5,134.0
4. EBITDA (1 – 2 – 3) 9,219.0 7,876.0 7,517.0 7,208.0 9,364.0 10,329.0
5. Depreciation and Amortization 5,678.0 5,890.0 5,670.0 5,908.0 6,107.0 5,908.0
6. EBIT (Pretax profit) (4 – 5) 3,541.0 1,986.0 1,847.0 1,300.0 3,257.0 4,421.0
7. Tax at 35% 1,239.4 695.1 646.5 455.0 1,140.0 1,547.4
8. Profit after tax (6 – 7) 2,301.7 1,290.9 1,200.6 845.0 2,117.1 2,873.7

9. Investment
6,547.0 7,345.0 5,398.0 5,470.0 6,420.0 6,598.0
(change in Gross PP&E)
10. Change in working capital 784.0 -54.0 -342.0 -245.0 127.0 235.0
11. Free Cash Flow (8 + 5 – 9 – 10) 648.7 -110.1 1,814.6 1,528.0 1,677.1 1,948.7

PV Free cash flow, years 1-4 3,501.6 Horizon value in year 4

PV Horizon value 15,480.0 24,358.1
PV of company 18,981.7
The total value of the equity is: $18,981.7 – $5,000 = $13,981.7
Value per share = $13,981.7/865 = $16.16