The High Country Water Company (HCWC) has a capital structure of 72% risky debt with a CAPM beta of 0.75 and 28% equity with a CAPM beta of 1.75. The current market value of HCWC is $6700 million, the riskless interest rate is 3% and the market risk premium is 8%. Assume that the corporate tax effects of debt alone approximate the overall tax and non-tax effects. The corporate tax rate is 34%. Given the current riskless and rate and market risk premium, calculate what the appropriate risk-adjused discount rate on HCWC equity would be if HCWC had zero debt. HCWC now announces that it is proposing to undertake a new scale-enhancing investment. In part to reduce its debt level, it will finance the new project entirely with a new equity issue. Ignore flotation costs. The up-front cost of the investment is $680 million. Starting one year hence, the project is expected to return an annual pre-tax cash flow of $250 million for 5 years at which time the project ends. Assume that the project has no liquidation value and no effect on HCWC net working capital requirements. HCWC will be able depreciate the initial investment on a straight-line basis over 5 years. It uses the riskless interest rate to discount the depreciation tax shield.
- Calculate the NPV of the project using the APV approach.
- Write down the market value balance sheet immediately after the project is announced but before the new equity has been sold.
- Write down the market value balance sheet immediately after the new equity has been sold.
- What is the new capital structure of HCWC after the new equity has been sold?
- Assuming that HCWC will manage its debt and equity outstanding to maintain the new capital structure, what should happen to the CAPM beta of its equity as a result of the announcement?