FIN322 Week 6 27/08/18

Chapter 18.

CQ:

4. Capital Budgeting

You are determining whether your company should undertake a new project and have calculated
the NPV of the project using the WACC method when the CFO, a former accountant, notices that
you did not use the interest payments in calculating the cash flows of the project. What should
you tell him? If he insists that you include the interest payments in calculating the cash flows,
what method can you use?

Ans: The WACC method does not explicitly include the interest cash flows, but it does implicitly
include the interest cost in the WACC. If he insists that the interest payments are explicitly
shown, you should use the FTE method.

QP:

10. APV

Triad Corporation has established a joint venture with Tobacco Road Construction, Inc., to build a
toll road in North Carolina. The initial investment in paving equipment is $93 million. The
equipment will be fully depreciated using the straight-line method over its economic life of five
years. Earnings before interest, taxes, and depreciation collected from the toll road are projected
to be $12.9 million per annum for 20 years starting from the end of the first year. The corporate
tax rate is 35 percent. The required rate of return for the project under all-equity financing is 13
percent. The pretax cost of debt for the joint partnership is 8.5 percent. To encourage investment
in the country’s infrastructure, the U.S. government will subsidize the project with a $30 million,
15-year loan at an interest rate of 5 percent per year. All principal will be repaid in one balloon
payment at the end of Year 15. What is the adjusted present value of this project?

Ans: The adjusted present value of a project equals the net present value of the project under all-
equity financing plus the net present value of any financing side effects. In the joint venture’s
case, the NPV of financing side effects equals the aftertax present value of cash flows resulting
from the firms’ debt. So, the APV is:

APV = NPV(All-Equity) + NPV (Financing Side Effects)

The NPV for an all-equity firm is:

NPV(All-Equity)

NPV = –Initial Investment + PV [(1 – tC) (EBITD)] + PV(Depreciation Tax Shield)

Since the initial investment will be fully depreciated over five years using the straight-line
method, annual depreciation expense is:

Annual depreciation = $93,000,000 / 5

Annual depreciation = $18,600,000

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NPV = –$93,000,000 + (1 – .35) ($12,900,000) PVIFA13%, 20 + (.35)($18,600,000)PVIFA8.5%,5

NPV = –$8,443,878.08
(Think about why using 8.5% instead of 13% in calculating the PV of depreciation tax shield)
NPV (Financing Side Effects)

The NPV of financing side effects equals the after-tax present value of cash flows resulting from
the firm’s debt. The coupon rate on the debt is relevant to determine the interest payments, but
the resulting cash flows should still be discounted at the pretax cost of debt. So, the NPV of the
financing effects is:

NPV = Proceeds – Aftertax PV (Interest Payments) – PV (Principal Repayments)

NPV = $30,000,000 – (1 – .35) (.05) ($30,000,000) PVIFA8.5%, 15 – $30,000,000 / 1.08515
NPV = $13,079,172.61
So, the APV of the project is:
(Please note that the way the aftertax PV (interest payments) is calculated has essentially
incorporated two effects that are discussed in the lecture: the benefit of lower interest rate and the
benefit of lower value of debt)
APV = NPV(All-Equity) + NPV (Financing Side Effects)
APV = –$8,443,878.08 + $13,079,172.61
APV = $4,635,294.52

11. APV

For the company in the previous problem, what is the value of being able to issue subsidized debt
instead of having to issue debt at the terms it would normally receive? Assume the face amount
and maturity of the debt issue are the same.

Ans: If the company had to issue debt under the terms it would normally receive, the interest rate on
the debt would increase to the company’s normal cost of debt. The NPV of an all-equity project
would remain unchanged, but the NPV of the financing side effects would change. The NPV of
the financing side effects would be:

NPV = Proceeds – Aftertax PV (Interest Payments) – PV (Principal Repayments)

NPV = $30,000,000 – (1 – .35) (.085) ($30,000,000) PVIFA8.5%, 15 – $30,000,000 / 1.08515
NPV = $7,411,531.14

Using the NPV of an all-equity project from the previous problem, the new APV of the project
would be:

APV = NPV(All-Equity) + NPV (Financing Side Effects)

APV = –$8,443,878.08 + $7,411,531.14
APV = –$1,032,346.94

The gain to the company from issuing subsidized debt is the difference between the two APVs,
so:

Gain from subsidized debt = $4,635,294.52 – (–1,032,346.94)

Gain from subsidized debt = $5,667,641.46

Most of the value of the project is in the form of the subsidized interest rate on the debt issue.

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13. WACC

Neon Corporation’s stock returns have a covariance with the market portfolio of .0415. The
standard deviation of the returns on the market portfolio is 20 percent, and the expected market
risk premium is 7.5 percent. The company has bonds outstanding with a total market value of $45
million and a yield to maturity of 6.5 percent. The company also has 4.2 million shares of common
stock outstanding, each selling for $30. The company’s CEO considers the firm’s current debt–
equity ratio optimal. The corporate tax rate is 35 percent, and Treasury bills currently yield 3.4
percent. The company is considering the purchase of additional equipment that would cost $47
million. The expected unlevered cash flows from the equipment are $13.5 million per year for five
years. Purchasing the equipment will not change the risk level of the firm.

(a) Use the weighted average cost of capital approach to determine whether Neon should
purchase the equipment.

(b) Suppose the company decides to fund the purchase of the equipment entirely with debt. What
is the cost of capital for the project now? Explain.

a. To calculate the NPV of the project, we first need to find the company’s WACC. In a world
with corporate taxes, a firm’s weighted average cost of capital equals:

RWACC = [B / (B + S)] (1 – tC) RB + [S / (B + S)] RS

The market value of the company’s equity is:

Market value of equity = 4,200,000($30)

Market value of equity = $126,000,000

So, the debt–value ratio and equity–value ratio is:

Debt/value = $45,000,000 / ($45,000,000 + 126,000,000)

Debt/value = .2632

Equity/value = $126,000,000 / ($45,000,000 + 126,000,000)

Equity/value = .7368

Since the CEO believes its current capital structure is optimal, these values can be used as
the target weights in the firm’s weighted average cost of capital calculation. The yield to
maturity of the company’s debt is its pretax cost of debt. To find the company’s cost of
equity, we need to calculate the stock beta. The stock beta can be calculated as:

 = S, M /  2M
 = .0415 / .202
 = 1.04

Now we can use the Capital Asset Pricing Model to determine the cost of equity. The
Capital Asset Pricing Model is:

RS = RF + β (RM – RF)
RS = 3.4% + 1.04(7.50%)
RS = 11.18%

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Now, we can calculate the company’s WACC, which is:

RWACC = [B / (B + S)] (1 – tC) RB + [S / (B + S)]RS

RWACC = .2632(1 – .35) (.065) + .7368(.1118)
RWACC = .0935, or 9.35%

Finally, we can use the WACC to discount the unlevered cash flows, which gives us an
NPV of:

NPV = –$47,000,000 + $13,500,000(PVIFA9.35%,5)

NPV = $5,035,988.82

b. The weighted average cost of capital used in part a will not change if the firm chooses to
fund the project entirely with debt. The weighted average cost of capital is based on optimal
capital structure weights. Since the current capital structure is optimal, all-debt funding for
the project implies that the firm will have to use more equity in the future to bring the
capital structure back towards the target.

14. Beta and Leverage

Dorman Industries has a new project available that requires an initial investment of $4.3 million.
The project will provide unlevered cash flows of $710,000 per year for the next 20 years. The
company will finance the project with a debt-to-value ratio of .40. The company’s bonds have a
YTM of 6.8 percent. The companies with operations comparable to this project have unlevered
betas of 1.15, 1.08, 1.30, and 1.25. The risk-free rate is 3.8 percent, and the market risk premium is
7 percent. The company has a tax rate of 34 percent. What is the NPV of this project?

Ans: We have four companies with comparable operations, so the industry average beta can be used
as the beta for this project. So, the average unlevered beta is:

Unlevered = (1.15 + 1.08 + 1.30 + 1.25) / 4

Unlevered = 1.20

A debt-to-value ratio of .40 means that the equity-to-value ratio is .60. This implies a debt–equity
ratio of .67{=.40/.60}. Since the project will be levered, we need to calculate the levered beta,
which is:

Levered = [1 + (1 – tC) (Debt/Equity)]Unlevered

Levered = [1 + (1 – .34) (.67)]1.20
Levered = 1.72

Now we can use the Capital Asset Pricing Model to determine the cost of equity. The Capital
Asset Pricing Model is:

RS = RF + β (RM – RF)
RS = 3.8% + 1.72(7.00%)
RS = 15.85%
Now, we can calculate the company’s WACC, which is:

RWACC = [B / (B + S)] (1 – tC) RB + [S / (B + S)]RS

RWACC = .40(1 – .34) (.068) + .60(.1585)
RWACC = .1130, or 11.30%

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Finally, we can use the WACC to discount the unlevered cash flows, which gives us an NPV of:

NPV = –$4,300,000 + $710,000(PVIFA11.30%,20)

NPV = $1,243,895.08

18. Projects That Are Not Scale Enhancing

Blue Angel, Inc., a private firm in the holiday gift industry, is considering a new project. The
company currently has a target debt–equity ratio of .40, but the industry target debt–equity ratio
is .35. The industry average beta is 1.2. The market risk premium is 7 percent, and the risk-free
rate is 5 percent. Assume all companies in this industry can issue debt at the risk-free rate. The
corporate tax rate is 40 percent. The project requires an initial outlay of $785,000 and is expected
to result in a $93,000 cash inflow at the end of the first year. The project will be financed at the
company’s target debt–equity ratio. Annual cash flows from the project will grow at a constant
rate of 5 percent until the end of the fifth year and remain constant forever thereafter. Should
Blue Angel invest in the project?

Since the company is not publicly traded, we need to use the industry numbers to calculate the
industry levered return on equity. We can then find the industry unlevered return on equity, and
re-lever the industry returns on equity to account for the different use of leverage. So, using the
CAPM to calculate the industry levered return on equity, we find:

RS = RF + β(MRP)
RS = 5% + 1.2(7%)
RS = 13.40%

Next, to find the average cost of unlevered equity in the holiday gift industry we can use
Modigliani-Miller Proposition II with corporate taxes, so:

RS = R0 + (B/S) (R0 – RB) (1 – tC)

.1340 = R0 + (.35) (R0 – .05) (1 – .40)
R0 = .1194, or 11.94%

Now, we can use the Modigliani-Miller Proposition II with corporate taxes to re-lever the return
on equity to account for this company’s debt–equity ratio. Doing so, we find:

RS = R0 + (B/S) (R0 – RB) (1 – tC)

RS = .1194 + (.40) (.1194 – .05) (1 – .40)
RS = .1361, or 13.61%
(Note that we can’t directly calculate Blue Angel’s Rs using the CAPM model because the
question only gives the industry beta, which is different from Blue Angel’s beta due to different
capital structure. This also suggests that an alternative approach is first find out Blue Angel’s
beta and then use the CAPM model to calculate Rs. You are encouraged to practice yourself.)
Since the project is financed at the firm’s target debt–equity ratio, it must be discounted at the
company’s weighted average cost of capital. In a world with corporate taxes, a firm’s weighted
average cost of capital equals:

RWACC = [B / (B + S)] (1 – tC) RB + [S / (B + S)]RS

So, we need the debt–value and equity–value ratios for the company. The debt–equity ratio for
the company is:

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B/S = .40
B = .40S

Substituting this in the debt–value ratio, we get:

B/V = .40S / (.40S + S)

B/V = .40 / 1.40
B/V = .29

And the equity–value ratio is one minus the debt–value ratio, or:

S/V = 1 – .29
S/V = .71

So, using the capital structure weights, the company’s WACC is:

RWACC = [B / (B + S)] (1 – tC) RB + [S / (B + S)]RS

RWACC = .29(1 – .40) (.05) + .71(.1361)
RWACC = .1058, or 10.58%

Now we need the project’s cash flows. The cash flows increase for the first five years before
leveling off into perpetuity. So, the cash flows from the project for the next six years are:

Year 1 cash flow $93,000.00

Year 2 cash flow $97,650.00
Year 3 cash flow $102,532.50
Year 4 cash flow $107,659.13
Year 5 cash flow $113,042.08
Year 6 cash flow $113,042.08

So, the NPV of the project is:

NPV = –$785,000 + $93,000 / 1.1058 + $97,650 / 1.10582 + $102,532.50 / 1.10583

+ $107,659.13 / 1.10584 + $113,042.08 / 1.10585 + ($113,042.08 / .1058) / 1.10585
NPV = $241,633.59

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