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You are a consultant who has been hired to evaluate a new product line for Markum...

You are a consultant who has been hired to evaluate a new product line for Markum Enterprises. The upfront investment required to launch the product line is $5 million. The product will generate a free cash flow of $ 0.70 million in the first​ year, and this free cash flow is expected to grow at a rate of 3% per year. Markum has an equity cost of capital of 11.4%, a debt cost of capital of 5.02 %, and a tax rate of 38 %. Markum maintains a​ debt-equity ratio of 0.70.

a. What is the NPV of the new product line​ (including any tax shields from​ leverage)?

b. How much debt will Markum initially take on as a result of launching this product​ line?

c. How much of the product​ line's value is attributable to the present value of interest tax​ shields?

(ROUND TO TWO DECIMAL PLACES)

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Answer #1

Investment = $5 Million.

Free Cash Flow = $0.70 Million.

Free Cash Flow Growth rate (g) = 3%.

Tax Rate = 38%.

Debt to Equity Ratio = 0.70.

Weight age of Equity (WE) = 1/1.7 = 58.82%.

Weight age of Debt (WD) = 100% – 58.82% = 41.18%.

Cost of Equity (KE) = 11.4%.

Cost of Debt (KD) = 5.02%.

Cost of Capital (WACC) = (WD) * (KD) * (1 – Tax Rate) + (WE) * (KE)

                                         = 41.18% * 5.02% * (1 – 38%) + 58.82% * 11.4%.

                                         = 1.28% + 6.70

                                       = 7.98%.

Value of Firm = 0.70 / (WACC – g)

                        = 0.70 / (7.98% - 3%)

                        = $14.05 Million.

NPV = Investment + Value of Firm

         = -5 + 14.05

         = 9.05 Million.

  1. NPV of the new project is 9.05 Million.

Debt to value ratio = 0.7/1.7 = 41.18%.

Therefore debt = 41.18% * $14.05 Million = $5.78 Million.

  1. Markum should take initially $5.78 Million as a debt for the new product line.

Unlevered WACC = (WD) * (KD) + (WE) * (KE)

                                         = 41.18% * 5.02% + 58.82% * 11.4%.

                                         = 2.06% + 6.70

                                       = 8.76%.

Value of Firm = 0.70 / (WACC – g)

                        = 0.70 / (8.76% - 3%)

                        = $12.15 Million.

Tax Shield Value = $14.05 - $12.15 = $1.9 Million.

c. We are getting a Tax Shield of $1.9 Million.

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