1. MEO Foods, Inc., has made cat food for over 20 years. The company currently has a debtequity ratio of 25 percent, borrows at a 10-percent interest rate, and is in the 40-percent tax bracket. Its shareholders require an 18-percent return.
MEO is planning to expand cat food production capacity. The equipment to be purchased would last three years and generate the following unlevered cash flows (UCF):
Year 0: -$15 million
Year 1: +$5 million
Year 2: +$8 million
Year 3: +$10 million
Year 4+: $0
MEO has also arranged a $6 million debt issue to partially finance the expansion. Under the loan, the company would pay 10 percent annually on the outstanding balance. The firm would also make year-end principal payments of $2 million per year, completely retiring the issue at the end of the third year.
Ignoring the costs of financial distress and issue costs, what is the APV of the expansion plans?
2. Milano Pizza Club owns a chain of three identical restaurants for their Milan style pizza. Each store has $270,000 in debt outstanding and a debt-to-equity ratio of 30 percent. The prevailing market interest rate is 9.5 percent. An equivalent all-equity financed store would have a discount rate of 15 percent. For each store, the estimated annual sales are $1,000,000, costs of goods sold are $400,000, and overhead costs are $300,000. Each of these cash flow streams is assumed to be a perpetuity. The corporate tax rate is 40 percent. Using the FTE approach, what is the value of Milano's Pizza Club?