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.