Problem 1 - NPV and APV
Zoso is a rental car company that is trying to determine whether to add 25 cars to its fleet. The company fully depreciates all its rental cars over six years using the straight-line method. The new cars are expected to generate $110.000 per year in earnings before taxes and depreciation for six years. The company is entirely financed by equity and has a 40 percent tax rate. The required return on the company's unlevered equity is 12 percent, and the new fleet will not change the risk of the company. The risk-free rate is it percent.
a. What is the maximum price that the company should be willing to pay for the new fleet of cars if it remains an all-equity company?
b. Suppose the company can purchase the fleet of cars for $385,000. Additionally, assume the company can issue $320,000 of six-year debt at the risk-free rate of 6 percent to finance the project. All principal will be repaid in one balloon payment at the end of the sixth year. What is the adjusted present value (APV) of the project?
Problem 2 - FTE
Milano Pizza Club owns three identical restaurants popular for their specialty pizzas. Each restaurant has a debt-equity ratio of 35 percent and makes interest payments of $54,000 at the end of each year. The cost of the firm's levered equity is 18 percent. Each store estimates that annual sales will be $1.56 million; annual cost of goods sold will be $800,000; and annual general and administrative costs will be $535.000. These cash flows are expected to remain the same forever. The corporate tax rate is 35 percent.
a. Use the flow to equity approach to determine the value of the company's equity.
b. What is the total value of the company?
Problem 3 - WACC
If Wild Widgets, Inc., were an all-equity company, it would have a beta of 1.65. The company has a target debt-equity ratio of .5. The expected return on the market portfolio is 10 percent, and Treasury bills currently yield 5.6 percent. The company has one bond issue outstanding that matures in 20 years and has a coupon rate of 10.2 percent. The bond currently sells for $1,240. The corporate tax rate is 35 percent.
a. What is the company's cost of debt?
b. What is the company's cost of equity?
c. What is the company's weighted average cost of capital?
Problem 4 - Beta and Leverage
North Pole Fishing Equipment Corporation and South Pole Fishing Equipment Corporation would have identical equity betas of 1.26 if both were all equity financed. The market value information for each company is shown here:
|
|
North Pole
|
South Pole
|
|
Debt
|
$3,060,000
|
$3,960,000
|
|
Equity
|
$3,960,000
|
$3,060,000
|
The expected return on the market portfolio is 12.5 percent, and the risk-free rate is 4.6 percent. Both companies are subject to a corporate tax rate of 40 percent. Assume the beta of debt is zero.
a. What is the equity beta of each of the two companies?
b. What is the required rate of return on each of the two companies' equity?
Problem 5 - WACC
Bolero, Inc., has complied the following information on its financing costs:
|
Type of Financing
|
Book Value
|
Market Value
|
Cost
|
|
Short-term debt
|
$11,400,000
|
$12,400,000
|
5.5%
|
|
Long-term debt
|
4,400,000
|
4,400,000
|
8.6
|
|
Common stock
|
7,400,000
|
27,400,000
|
15.2
|
|
Total
|
$23,200,000
|
$44,200,000
|
|
The company is in the 34 percent tax bracket and has a target debt-equity ratio of 75 percent. The target short-term debt/long-term debt ratio is 10 percent.
a. What is the company's weighted average cost of capital using book value weights?
b. What is the company's weighted average cost of capital using market value weights?
c. What is the company's weighted average cost of capital using target capital structure weights?
d. Which is the correct WACC to use for project evaluation?
- Target weights
- Market weights
- Book weights
Problem 6 - APV
MVP, Inc., has produced rodeo supplies for over 20 years. The company currently has a debt-equity ratio of 50 percent and is in the 35 percent tax bracket. The required return on the firm's levered equity is 19 percent. The company is planning to expand its production capacity. The equipment to be purchased is expected to generate the following unlevered cash flows:
|
Year
|
Cash Flow
|
|
0
|
-$17,200,000
|
|
1
|
5,760,000
|
|
2
|
9,560,000
|
|
3
|
8,860,000
|
The company has arranged a debt issue of 59.48 million to partially finance the expansion. Under the loan, the company would pay interest of 9 percent at the end of each year on the outstanding balance at the beginning of the year. The company would also make year-end principal payments of $3,160,000 per year, completely retiring the issue by the end of the third year.
Calculate the APV of the project.
Problem 7 - Beta and Leverage
Dorman Industries has a new project available that requires an initial investment of $6.4 million. The project will provide unlevered cash flows of $865,000 per year for the next 20 years. The company will finance the project with a debt-to-value ratio of .3. The company's bonds have a YTM of 5.8 percent. The companies with operations comparable to this project have unlevered betas of 1.34, 1.27, 1.49, and 1.44. The risk-free rate is 2.8 percent, and the market risk premium is 6 percent. The company has a tax rate of 40 percent.
What is the NPV of this project?
Problem 8 - APV, FTE, and WACC
Mojito Mint Company has a debt-equity ratio of .20. The required return on the company's unlevered equity is 13 percent, and the pretax cost of the firm's debt is 8.7 percent. Sales revenue for the company is expected to remain stable indefinitely at last year's level of $19,200,000. Variable costs amount to 60 percent of sales. The tax rate is 34 percent, and the company distributes all its earnings as dividends at the end of each year.
a. If the company were financed entirely by equity, how much would it be worth?
b. What is the required return on the firm's levered equity?
c-1. Use the weighted average cost of capital method to calculate the value of the company.
c-2. What is the value of the company's equity?
c-3. What is the value of the company's debt?
d. Use the flow to equity method to calculate the value of the company's equity.
Problem 9 - Projects That Are Not Scale Enhancing
Blue Angel, Inc., a private firm in the holiday gift industry, is considering a new project. The company currently has a target debt-equity ratio of .40, but the industry target debt-equity ratio is .35. The industry average beta is 2.00. The market risk premium is 6 percent, and the risk-free rate is 4 percent. Assume all companies in this industry can issue debt at the risk-free rate. The corporate tax rate is 35 percent. The project requires an initial outlay of $695,000 and is expected to result in a $115,000 cash inflow at the end of the first year. The project will be financed at the company's target debt-equity ratio. Annual cash flows from the project will grow at a constant rate of 4 percent until the end of the fifth year and remain constant forever thereafter.
Calculate the NPV of the project.