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CF - Questions and Practice Problems - Chapter 18

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49 views5 pages

CF - Questions and Practice Problems - Chapter 18

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Mai Phạm
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Corporate Finance

Questions and Practice problems_Chapter 18

Chapter 18:
Concept questions (page 574 textbook): 2, 3, 4
Questions and Problems (page 575 textbook): 3, 5, 8

Concept question 2: What is the main difference between the WACC and APV methods?
=> The WACC is based on a target debt level while the APV is based on the amount of debt.

Concept question 3: What is the main difference between the FTE approach and the other two
approaches?
=> FTE uses levered cash flow and other methods use unlevered cash flow

Concept question 4: You are determining whether your company should undertake a new
project and have calculated the NPV of the project using the WACC method when the
CFO, a former accountant, notices that you did not use the interest payments in calculating
the cash flows of the project. What should you tell him? If he insists that you include the
interest payments in calculating the cash flows, what method can you use?

=>The WACC method does not


explicitly include the interest cash
flows, but it does implicitly
include
the interest cost in the WACC. If
he insists that the interest
payments are explicitly shown,
you
should use
=> The WACC method does not explicitly include the interest cash flows, but it does implicitly
include the interest cost in the WACC. If he insists that the interest payments are explicitly
shown, you should use the FTE method.

Concept question 5: What are the two types of risk that are measured by a levered beta?

=>You can estimate the unlevered


beta from a levered beta. The
unlevered beta is the beta of the
assets
of the firm; as such, it is a measure
of the business risk. Note that the
unlevered beta will always be
lower than the levered beta
(assuming the betas are positive).
The difference is due to the
leverage of
the company. Thus, the second risk
factor measured by a levered beta
is the financial risk of the
company
=> You can estimate the unlevered beta from a levered beta. The unlevered beta is the beta of the
assets of the firm; as such, it is a measure of the business risk. Note that the unlevered beta will
always be lower than the levered beta (assuming the betas are positive). The difference is due to
the leverage of the company. Thus, the second risk factor measured by a levered beta is the
financial risk of the company.

Problems

Problem 1: 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 five years using the
straight-line method. The new cars are expected to generate $175,000 per year in earnings
before taxes and depreciation for five years. The company is entirely financed by equity
and has a 35 percent tax rate. The required return on the company’s unlevered equity is 13
percent, and the new fleet will not change the risk of the company.
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 $480,000. Additionally, assume
the company can issue $390,000 of five-year, 8 percent debt to finance the project. All
principal will be repaid in one balloon payment at the end of the fifth year. What is the
adjusted present value (APV) of the project?

=> a) EBIT = $175,000


NPV = initial cost + depreciation tax shield + present value of ebit = 0
-P + 0.35*P/5*1/0.8%*(1-1/1.08^5) + 65%*175,000/13%*(1-1/1.13^5) = 0
-P + 0.2795*P + 400,085 =0
=> P = $555,287

b) Depreciation = 480,000/5 = $96,000


Interest after tax per year = 390,000*8%*(1-35%) = 20,280
NPV(all equity) = -480,000 + 35%*96,000/8% * (1-1/1.08^5) + 65%*175,000/13%*(1-
1/1.13^5) = 54,240.11
NPV (loan) = Proceeds – PV of after tax interest – PV of principle payment

Problem 3: Milano Pizza Club owns three identical restaurants popular for their specialty
pizzas. Each restaurant has a debt–equity ratio of 40 percent and makes interest payments
of $41,000 at the end of each year. The cost of the firm’s levered equity is 19 percent. Each
store estimates that annual sales will be $1.3 million; annual cost of goods sold will be
$670,000; and annual general and administrative costs will be $405,000. These cash flows
are expected to remain the same forever. The corporate tax rate is 40 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?
=> a.
Sales 1,300,000
COGS 670,000
Annual G&A 405,000
EBIT 225,000 (1,3m-670k-405k)
Interest 41,000
EBT 184,000 (405k-41k)
Tax (40%) 73,600 (184,000*40%)
Net profits 110,400

Value of equity for one restaurant = Profits / Cost of equity = LCF/Rs= 110,400/19% =
$581,052. 63
Value of company’s equity = 581,052. 63*3 = $1,743,157.9

b. Debt to equity = B/S =40% => B = 0.4S


V= B + S = 0.4*1,743,157.9 + 1,743,157.9
=> Company value = $2,440,421.053

Problem 5: 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?

=> a. North Pole:


D/E Ratio = Debt/Equity = 2,900,000/3,800,000 = 0.76
Levered beta = Unlevered beta * (1+(1-tax)*D/E ratio) = 1.10*(1+(1-0.35)*0.76)= 1.65
Required Return = Risk-free Rate + Levered Beta*(Market return – Risk-free rate)
Rs = Rf + Beta (Rm-Rf) = 3.2% + 1.65*(10.9%-3.2) = 15.91%
b. South Pole:
D/E Ratio = Debt/Equity = 3,800,000/2,900,000 = 1.31
Levered beta = Unlevered beta * (1+(1-tax)*D/E ratio) = 1.10*(1+(1-0.35)*1.31)= 2.04
Required Return = Risk-free Rate + Levered Beta*(Market return – Risk-free rate)
= 3.2% + 2.04*(10.9%-3.2) = 18.91%

Problem 7: Shattered Glass, Inc., is an all-equity firm. The cost of the company’s equity is
currently 11 percent, and the risk-free rate is 3.5 percent. The company is currently
considering a project that will cost $11.4 million and last six years. The project will
generate revenues minus expenses each year in the amount of $3.2 million. If the company
has a tax rate of 40 percent, should it accept the project?

=> = -11.4 + 3.2*(1-40%)/11% * (1-1/(1+11%)^6) + (11.4/6*40%)/3.5% * (1-1/(1+3.5%)^6)


= 0.77 million > 0 => accept the project

Problem 8: National Electric Company (NEC) is considering a $45 million project in its
power systems division. Tom Edison, the company’s chief financial officer, has evaluated
the project and determined that the project’s unlevered cash flows will be $3.1 million per
year in perpetuity. Mr. Edison has devised two possibilities for raising the initial
investment: Issuing 10-year bonds or issuing common stock. NEC’s pretax cost of debt is
6.9 percent, and its cost of equity is 10.8 percent. The company’s target debt-to-value ratio
is 80 percent. The project has the same risk as NEC’s existing businesses, and it will
support the same amount of debt. NEC is in the 34 percent tax bracket. Should NEC accept
the project?

=> Rb = 6.9%; Rs = 10.8%

= 0.2*10.8% + 0.8*6.9%*(1-34%) = 5.8%

UCF 3.1
NVP = −INV = −45=$ 8.45 million > 0 => accept the project
WACC 5.8 %

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