A firm has decided to take a project that requires an initial investment of $2 million. If funded entirely with equity, the firm expects the project to generate net operating cash flows (after tax) during the project's twenty five year life as follows:
Years 1-5 6-10 11-15 16-20 Project cash flow $300,000 $350,000 $400,000 $4250,000
20-25
$500,000
The firm also expects to net $450,000 (after tax) from sale of equipment and recovery of working capital at the end of the project. The firm plans to fund 35% of the initial investment with 25 year debt (interest only) that will bear interest at 4%, and estimates that the asset beta for comparable projects is 1.31. The risk free interest rate is 3% and the firm expects the market return over the next 25 years to average 11.5%. The project will be operated as a corporation with a combined federal and state income tax rate of 40%.
1a. Determine the required return on the project if it is funded entirely with equity.
b. Calculate the value of the project if funded entirely with equity.
2a. Find the levered equity beta.
b. Calculate the required return on levered equity.
c Determine the weighted average cost of capital.
d. Using the WACC method, what is the value of the levered project?
3a. Calculate the amount of the each interest payment on the loan.
b. Calculate the present value of the interest payments.
c. Determine the value of the tax shield of interest.
d. Using the APV method, what is the value of the levered project?
4a. Determine the initial investment by equity in the project.
b. Determine the cash flow to equity in each year of the project.
c. Using the FTE method, what is the value of the levered project?