Question 1:
The firm wants to diversify with a new product line. The project requires an initial investment of $8,000,000 and will provide $2,750,000 in after-tax unlevered cash flows at the end of each year for 7 years. The project's unlevered cost of capital is 12%. The firm's target debt-equity ratio is 1.50. Debt (bonds) of $6,000,000 will be issued. Assume the debt has a 7-year life, a yield of 5% and a coupon of 5%. The tax rate is 40%.
a. Find the value of the project using APV (adjusted present value). You will need to estimate the unlevered cost of capital.
b. Find the value of the project using FTE (flow to equity).
Question 2:
Brain Drain is about to launch a new product. Depending on the success of the new product, there arethree possible outcomes for value next year: $210 million, $150 million or $60 million. These outcomes are all equally likely, and this risk is diversifiable. Suppose the risk-free interest rate is 5%. (Ignore all other market imperfections, such as taxes.). Brain Drain has $120 million in debt due next year.
a. What is Brain's total value with leverage?
b. Now suppose that in the event of default, 30% of the value of Brain's assets will be lost to bankruptcy costs. What is Brain's total value with leverage and distress costs?