Question

You are a consultant who has been hired to evaluate a new product line for Markum Enterprises. The upfront investment required to launch the product line is

$15 million. The product will generate free cash flow of $0.77 million the first​ year, and this free cash flow is expected to grow at a rate of

4% per year. Markum has an equity cost of capital of 11.7%​, a debt cost of capital of 9.28%​, and a tax rate of 38%. Markum maintains a​ debt-equity ratio of 0.50.

a. What is the NPV of the new product line​ (including any tax shields from​ leverage)?

b. How much debt will Markum initially take on as a result of launching this product​ line?

c. How much of the product​ line's value is attributable to the present value of interest tax​ shields?

Answer 1

a)

Caluculation of Weighted avearge cost of capital

WACC = (1 / 1.5)x(11.7%) + (.5 / 1.5)x(9.28%)(1 – .38)

= 7.79%+ 1.91%= 9.717%

Present value of perpetual  cash inflow = 0.77 / (0.09717 −.04 ) = $13.4665 million

Net present value = -15+ 13.4665 = - $1.5334million

b)

Debt-to-Equity ratio .5 .5/1.5 = 33.33%.

Therefore Debt required  33.33% ×13.4665 $million = $4.4888million.

C) Unlevered value. Ru = (1 / 1.5)x(11.7%) + (.5 / 1.5)x(9.28%) = 10.893%

Value unlevered  = 0.77 / (10.893% − 4%) = $11.1702 million
Tax shield value   13.4665 – 11.1702 = $2.2963 million.

or we show this another way

Inital debt value= 4.4888million* 9.28%*.38= 0.15829/(.10893-.04)= $2.2963 million