Question

(1)You are thinking of starting a new project. You do a cash-flow analysis and estimate that...

(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.

Homework Answers

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.
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