Question

8. An all-equity firm is considering financing its next
investment project with a combination of equity and debt. The asset
beta for the firm as a whole is 1.2 (recall that this is the same
as the equity beta for an all-equity firm, but not the same as the
equity beta for a “levered” firm). Assume the average rate of
return on the market is 6% and the risk-free rate is 1%. The cost
of debt for the company is 3% and it faces a corporate tax rate of
20%. The investment will generate *net cash flow* of $1,000
per year in perpetuity starting one year from today. Assume that
the $1,000 per year in cash flow is *net* of the investing
activities in the project, so when calculating the NPV you don’t
need to subtract the investment cost.

a. Find the NPV of the project if it is financed entirely with equity.

b. Find the NPV of the project if it is financed with 60% equity and 40% debt. In this case, the equity beta is not identical to the asset beta (due to the leverage) and so you will need to calculate the equity beta before you can determine the firm’s cost of equity capital. You can assume the beta on debt is zero.

Answer #1

If Inc. were an all-equity firm, it would have a beta of 1.2.
The market risk premium is 10 percent, and the return on government
bond is 2 percent.
The company has a debt-equity ratio of 0.65, which, according to
the CFO, is optimal. Soroc Inc. is considering a project that
requires the initial investment of $28 million. The CFO of the firm
has evaluated the project and determined that the project’s free
cash flows will be $3.3 million per...

If Soroc Inc. were an all-equity firm, it would have a beta of
1.5. The market risk premium is 10 percent, and the return on
government bond is 2 percent.
The company has a debt-equity ratio of 0.65, which, according to
the CFO, is optimal. Soroc Inc. is considering a project that
requires the initial investment of $28 million. The CFO of the firm
has evaluated the project and determined that the project’s free
cash flows will be $3.3 million...

Assume CAPM holds and you have the following information
regarding three investment opportunities:
Project 1 has a project beta of 2.0 and you have estimated that
the project’s NPV using a cost of capital of 20% equals zero.
Project 2 has a project beta of 1.5 and its NPV using a cost of
capital of 10% equals zero. Lastly, project 3 has a project beta of
1.0 and its NPV equals zero using a cost of capital of 6%. None...

[Q18-Q23] You are evaluating a 1-year project that is in line
with the firm’s existing business. Specifically, this new project
requires an investment of $1,200 in free cash flow today, but will
generate $1,600 one year from today. The project will be partially
financed with a 1-year maturity debt whose face value is $200 and
interest rate is 10%.
Suppose that you estimated the cost of equity as 20%, based on
the firm’s stock data. However, you were not able...

Blue Angel, Inc., a private firm in the holiday gift industry,
is considering a new project. The company currently has a target
debt–equity ratio of .30, but the industry target debt–equity ratio
is .25. The industry average beta is 1.40. The market risk premium
is 8 percent, and the risk-free rate is 6 percent. Assume all
companies in this industry can issue debt at the risk-free rate.
The corporate tax rate is 35 percent. The project requires an
initial outlay...

The Rodriguez Company is considering an average-risk investment
in a mineral water spring project that has a cost of $160,000. The
project will produce 750 cases of mineral water per year
indefinitely. The current sales price is $145 per case, and the
current cost per case is $110. The firm is taxed at a rate of 36%.
Both prices and costs are expected to rise at a rate of 6% per
year. The firm uses only equity, and it has...

The capital structure of a company consists of debt and equity.
The firm has 100,000 bonds outstanding that are selling at par
value. The par value of each bond is $1,000. Bonds with similar
characteristics are yielding a before-tax return of 8 percent. The
company also has 10 million shares of common stock outstanding. The
stock has a beta of 1.5 and sells for $30 a share. The return on
U.S. Treasury bills is 4 percent and the market rate...

Consider a project with free cash flow in one year of
$140,738
or
$162,796,
with either outcome being equally likely. The initial investment
required for the project is
$80,000,
and the project's cost of capital is
18%.
The risk-free interest rate is
11%.
(Assume no taxes or distress costs.)
a. What is the NPV of this project?
b. Suppose that to raise the funds for the initial investment,
the project is sold to investors as an all-equity firm. The equity...

Blue Angel, Inc., a private firm in the holiday gift industry,
is considering a new project. The company currently has a target
debt–equity ratio of .30, but the industry target debt–equity ratio
is .25. The industry average beta is 1.40. The market risk premium
is 8 percent, and the risk-free rate is 6 percent. Assume all
companies in this industry can issue debt at the risk-free rate.
The corporate tax rate is 35 percent. The project requires an
initial outlay...

Blue Angel, Inc., a private firm in the holiday gift industry,
is considering a new project. The company currently has a target
debt–equity ratio of .40, but the industry target debt–equity ratio
is .35. The industry average beta is 1.20. The market risk premium
is 8 percent, and the risk-free rate is 6 percent. Assume all
companies in this industry can issue debt at the risk-free rate.
The corporate tax rate is 40 percent. The project requires an
initial outlay...

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