Question

(1)You are thinking of starting a new project. You do a cash-flow analysis and estimate that the project will give you a free cash flow of $50M in one year and the free cash flows will grow at a rate of 2% per year perpetually.

The equity beta for a firm similar to your proposed project is 1.4. This similar firm has $300M of risk-free debt outstanding and has 300 million shares, each valued at $5 each. It also has a target leverage ratio (fixed D/V) policy.

Your firm has a target debt-to-equity ratio of 0.5 and your debt is risk free. Assume that the risk-free rate is 6%, that the market risk premium is 8.4% and that the corporate tax rate is 34%.

Determine how much your project is worth using the WACC approach.

(2)True or False: For a US firm financed by both debt and equity, the before-tax cost of debt is the same as the after-tax cost of debt for firms making zero taxable income. Briefly explain for your answer.

Answer 1

1]	The first step is to find the unlevered equity beta.
	Unlevered equity beta = 1.4/(1+0.66*1/5) =	1.24
	[D/E ratio = 300/(300*5)
	Relevering equity beta to target debt-equity ratio = 1.24*(1+0.66*0.5) =	1.65
	After tax cost of debt = 6%*(1-34%) =	3.96%
	Cost of equity per CAPM = 6%+1.65*8.4% =	19.86%
	WACC = 3.96%*0.5/1.5+19.86%*1/1.5 =	14.56%
	Worth of the project = 50/(0.1456-0.02) =	$           398.09	Million
2]	True.
	After tax cost of debt = Before tax cost of debt*(1-tax rate)
	When taxable income is 0, the after tax cost of debt is the
	same as the before tax cost of debt.