Question

1. A company is about to undertake a new project. In a Modigliani and Miller world with only tax, the cash flows are given as following.

1. year	2. year	3. year	4. year	5. year
10	10	10	10	10

Risk free rate =3%, cost of debt = 6% and return on equity =15%. The CEO calculated NPV as 0. Thus, he is indifferent in terms of undertaking the project and does not know what to do. When you checked the CEO’s calculations, you realized that the company debt (D/V ratio) increased in financing this new project and the CEO use the old return on equity.   

Evaluate the decision of the CEO on the project and help him to decide what to do!

Answer 1

Since D/V ratio has increased in the new scenario ; according to Modigliani and Miller Proposition 1 with tax ; the value of the more levered firm will be higher than the less levered firm by an amount of debt* tax rate;

VL = VUL + D*t ( VUL=Value of Unlevered firm ;VL =Value of levered firm )

Also as per Modigliani and Miller proposition 2 with taxes ; the WACC reduce due to the tax benefit in the debt;

WACC = ke ×E+ kd × (1 - t) ×D/V

Considering both ; the value of the firm has to be positive; ie npv will be positive compared to what the ceo has calculated and hence the company can go with the project.

PS: Not sure using these cashflows how the CEO got npv as zero. It will be positive unless there is a cash outflow.

1. year	2. year	3. year	4. year	5. year
10	10	10	10	10