Cent Investments Ltd is considering a project that will result in initial cash savings of $5 million at the end of the first year, and these savings will grow at the rate of 3.2% per year indefinitely. The firm has a debt/equity ratio of 4.0, a cost of equity of 12%, and an after-tax cost of debt of 6%. The cost-saving proposal is related to the firm’s core business, so it is viewed as having the same risks as the overall firm. Under what circumstances should the firm take on the project?
WACC = 7.20%
PV of cash savings = $125,000,000 ?
Thus, the firm should take on the project if the initial investment cost of the project is less than $125 million.
5. EOCQ 20) The Mark ...view middle of the document...
Also using debt has certain implicit consequences, such as increasing the financial risk of the firm and increasing the likelihood of potential bankruptcy, which detract from the benefits of the lower explicit cost.
* It may be better for the company to use a mix of debt and equity finance in line with its target capital structure.
b) What is the NPV of the project?
The firm’s WACC is calculated as follows (assuming that it funds the project in identical proportions to its target capital structure):
WACC = (0.16)(1/4) + (0.08)(3/4)(1-0.30) = 0.082 (8.2%)
Need to determine the weighted flotation costs associated with the project and adjust the total funds required for these flotation cost effects:
Weighted flotation costs (fA) = (0.15)(1/4) + (0.01)(3/4) = 0.045 (4.5%)
Total project costs = $20,000,000/(1 – 0.045) = $20,942,408
PV of project cash flows = $8,000,000/0.082 = $97,560,976
NPV = $97,560,976 - $20,942,408 = $76,618,567
Thus Mark Models Company Ltd should undertake the expansion project as it has a positive NPV.
4. EOCQ 5) Here Pty Ltd and Now Pty Ltd are identical firms in every way except for capital structure (Now uses perpetual debt). The EBIT for both is expected to be $16 million forever. The shares of Here are worth $100 million, and the shares of Now worth $50 million. The interest rate is 8 per cent, and there are no taxes. Awake owns $1 million of Now’s shares.
What rate of return is Awake expecting?
Expected return can be calculated as:
b) Show how Awake could generate exactly the same cash flow and rate of return by investing in Here and using ‘home-made’ leverage.
Awake currently has a 1/50 ownership in Now’s shares.
Achieving a 1/50 share in Here involves acquiring shares in Here totaling $2 million ($100 million 1/50)
* This can be achieved by selling his shares in Now for $1 million, borrowing $1 million at the 8% interest rate and buying $2 million of Here shares
Cash flow from investment in Here = ($2 million 0.16) – ($1 million 0.08) = $240,000
Previous cash flow from investment in Now = ($1 million 0.24) = $240,000
c) What is the cost of equity for Now? Compare your answer to your answer in part a). What do you notice? Explain?
Return on equity for the all-equity firm (Here) = $16/$100 = 0.16 (16%)
Return on equity for the levered firm (Now) is calculated as:
RE = RU + (RU – RD)D/E = 0.16 + (0.16 – 0.08)(50/50) = 0.24 (24%)
In comparison with part a), the cost of equity and the expected return on equity are the same.
* Also note that the cost of equity in the levered firm is higher than that for the unlevered firm, with the difference being the financial risk premium demanded by Now shareholders.
d) What is Here’s weighted average cost of capital? What is the weighted average cost of capital for Now? What principle does your answer illustrate?
WACC for Here = (0.16)($100/$100) + (0.08)($0/$100) = 0.16 (16%)
WACC for Now =...