Question

Your firm’s market value balance sheet is given as follows: Market Value Balance Sheet Excess cash...

Your firm’s market value balance sheet is given as follows:

Market Value Balance Sheet

Excess cash

$30M

Debt

$230M

Operating Assets

$500M

Equity

$300M

Asset Value

$530M

Debt + Equity

$530M

Assume that the you plan to keep the firm’s debt-to-equity ratio fixed. The firm’s corporate tax rate is 50%. The firm’s cost of debt is 10% and cost of equity is 20%.

Now, suppose that you are considering a new project that will last for one year. According to your analysis, free cash flows from the project are -$1,000 today (i.e. year 0) and $1,322.40 one year from today (i.e. year 1). This new project can be viewed as a “carbon copy” of the entire firm’s existing business. You want to find the NPV of the project using three different DCF methods: WACC/APV/FTE.

QUESTION 1

What is the firm’s WACC?

A.

10%

B.

14%

C.

20%

D.

16%

QUESTION 2

Under the WACC approach, the NPV of the project is obtained by discounting future ______ using the WACC.

A.

Free cash flow to equity

B.

Tax savings

C.

Free cash flow to debt

D.

Free cash flow

QUESTION 3

What is the NPV based on the WACC approach?

A.

$140

B.

$20

C.

$200

D.

$160

QUESTION 4

What is the firm’s unlevered cost of capital?

A.

14%

B.

16%

C.

10%

D.

20%

Homework Answers

Answer #1

Q1.

Please refer to the calculations in screenshot below:

Q2.

Option D: Future Free cash flows are used for calculation of NPV after discounting them with WACC.

Q3.

Please refer to the calculations in screenshot below:

So the NPV is $160

Q4.

The cost of capital of unlevered firm will be same as the cost of equity = 20% (Option D)

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