Question

Tomkat Corp. has only a single asset. This asset generates operating cash flow of $200,000 per year, in perpetuity. Tomkat also has a single liability, which is a perpetual bond (the maturity date is infinitely far in the future) that has a face value of $1 million and that pays coupon interest at a rate of 8% once per year. The appropriate discount rate for all cash flows in this problem is 10% per year. (a) What is the value of Tomkat’s equity? Assume now, that in addition to the asset and liability described above, Tomkat is working on a new project. The project requires an immediate investment of $400,000, and will require another investment of $600,000 a year from now. Two years from now the project will generate a positive operating cash flow of $60,000, and subsequent operating cash flows will grow by 5% per year in perpetuity. Continue to assume a discount rate of 10% per year. (b) What is the value of Tomkat’s equity given the existence of this “growth opportunity”?

Answer 1