Question

Your firm is considering building a $590 million plant to
manufacture HDTV circuitry. You expect operating profits (EBITDA)
of $141 million per year for the next ten years. The plant will be
depreciated on a straight-line basis over ten years (assuming no
salvage value for tax purposes). After ten years, the plant will
have a salvage value of $299 million (which, since it will be
fully depreciated, is then taxable). The project requires $50
million in working capital at the start, which will be recovered
in year ten when the project shuts down. The corporate tax rate is
35%. All cash flows occur at the end of the year.

a. If the risk-free rate is 4.5%, the expected return of the
market is 11.8%, and the asset beta for the consumer electronics
industry is 1.67, what is the NPV of the project?

b. Suppose that you can finance $472 million of the cost of
the plant using ten-year, 9.3% coupon bonds sold at par. This
amount is incremental new debt associated specifically with this
project and will not alter other aspects of the firm's capital
structure. What is the value of the project, including the tax
shield of the debt?

Answer #1

a)

Required rate of return calculated as follows

Required rate of return= Risk free rate + Beta ( Expected return of market - Risk free return)

= 4.5% + 1.67(11.8%-4.5%)

=16.691 or16.70%

Calculation of NPV

Item years Amount of casflows Tax effect Ater tax casflow 16.70% factor Present value of casflows

(a) (b) (a) * (b) =c

EBITDA 1-10 $141million 0.65 91.65 4.710 431.6715

Depreciation 1-10 $59 million 0.35 20.65 4.710 97.2615

Salvage value 10 $299 million 0.65 194.35 0.213 41.39655

working capital 10 $50 million - 50.00 0.213 10.65

Plant cost 0 $590million - (590.00) 1 (590.00)

working capital 0 $50 million - (50.00) 1 (50.00)

Net Present value (59.02045)million

The NPV of project is negative , we should not accept the project.

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