Question

You have the following initial information on CMR Co. on which to base your calculations and discussion for Two parts A) and B):

• Current long-term and target debt-equity ratio (D:E) = 1:4

• Corporate tax rate (TC) = 30%

• Expected Inflation = 1.75%

• Equity beta = 1.6385

• Debt beta = 0.2055

• Expected market premium (r_M – r_F) = 6.00%

• Risk-free rate (r_F) = 2.15%

A) The CEO of CMR Co., for which you are CFO, has requested that you evaluate a potential investment in a new project. The proposed project requires an initial outlay of $7.15 billion. Once completed (1 year from initial outlay) it will provide a real net cash flow of $575 million in perpetuity following its completion. It has the same business risk as CMR Co.’s existing activities and will be funded using the firm’s current target D:E ratio.

i) What is the nominal weighted-average cost of capital (WACC) for this project?

ii) As CFO, do you recommend investment in this project? Justify your answer (numerically).

B) Assume now a firm that is an existing customer of CMR Co. is considering a buyout of CMR Co. to allow them to integrate production activities. The potential acquiring firm’s management has approached an investment bank for advice. The bank believes that the firm can gear CMR Co. to a higher level, given that its existing management has been highly conservative in its use of debt. It also notes that the customer’s firm has the same cost of debt as that of CMR Co. Thus, it has suggested use of a target debt-equity ratio of 2:6 when undertaking valuation calculations.

i) What would the required rate of return for BFS Co.’s equity become if the proposed gearing structure were adopted following acquisition by the customer?

ii) Would the above project described in 1) be viable for the new owner of BFS Co.? Justify your answer (numerically).

Please submit Part A and B answers to the following questions in Excel file format (i.e., as an Excel file), and in clear way

Answer 1

Following is the data given in the question:

Given data
Current long-term and target debt-equity ratio (D:E)	01:04
Corporate tax rate (TC)	30.00%
Expected Inflation	1.75%
Equity beta	1.64
Debt beta	0.21
Expected market premium (rM – rF)	6.00%
Risk-free rate (rF)	2.15%
cash flow from year 2	575.00

A) The data for this part of the question is as below:

% Debt	20%
% equity	80%

i) The cost of wacc using the below formula is also given in the table:

wacc = (equity %)*(cost of equity)+(debt %)*(cost of debt)*(1-tax rate), we get

Cost of equity	11.98%
Cost of debt	3.38%
wacc	10.06%

ii) We not calculate the NPV of the project, using above, we get,

Year	1	2
Cash flow	-7150	7,042
NPV	-683

The NPV is negative and hence this is not a good investment

B) The new cost of capital is calculated below, similar ot the first part:

% Debt	33%
% equity	67%
Cost of equity	11.98%
Cost of debt	3.38%
wacc	8.78%

Now, we will calculate NPV of this project:

Year	1	2
Cash flow	-7150	8,326
NPV	463

As the NPV (Net present value) of the cash flow is positive, its value accretive for the company and company should go for it with this Debt by Equity ratio