Question

Please Answer Question 2 Only:

You have the following initial information on CMR Co. on which to base your calculations and discussion for questions 1) and 2):
• Current long-term and target debt-equity ratio (D:E) = 1:4
• Corporate tax rate (TC) = 30%
• Expected Inflation = 1.75%
• Equity beta (E) = 1.6385
• Debt beta (D) = 0.2055
• Expected market premium (rM – rF) = 6.00%
• Risk-free rate (rF) = 2.15%

^{1) 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.
a) What is the nominal weighted-average cost of capital (WACC) for this project?
b) As CFO, do you recommend investment in this project? Justify your answer (numerically).}

Please Answer Question 2 Only:

2) 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.
a) 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?
b) Would the above project described in 1) be viable for the new owner of BFS Co.? Justify your answer (numerically).

Please Only answer Question 2: Question 1 has been given for context of the question

Answer 1

Answer for question 2 as requested.

2)

a) Given Tax rate = 30%, Equity Beta (Beta) = 1.6385, Market Premium = 6%, Risk Free Rate = 2.15%

First we have to calculate the beta for new debt-equity ratio of 2:6.

Step 1: Unlever the equity beta using Debt to equity ratio of 1:4.

Unlevered Beta (Asset Beta) = Equity Beta / ( 1+ (1-Tax Rate) * Debt/Equity) + Debt Beta * ( 1 - Tax Rate) / (( Equity/Debt) + (1-Tax Rate))

= 1.6385 / ( 1+ (1 - 0.3) * (1/4)) + 0.2055 * ( 1 - 0.3) / ( 4 + 0.7)

= 1.6385 / 1.175 + 0.1439/4.7= 1.3945 + 0.0306 = 1.4251

Step 2: Lever the beta using new Debt to Equity Ratio of 2:6

Levered Beta = Unlevered Beta * (1 + (1 - Tax Rate) * Debt/Equity)

= 1.4251 * (1 + (1 - 0.3) * (2/6))

= 1.4251 * 1.2333 = 1.7576

Step 3: Calculate the cost of Equity

Cost of Equity = Risk Free Rate + Levered Beta * Market Risk Premium

= 2.15% + 1.7576 * 6.00%

= 12.70%

The required rate of return for BFS Co.’s equity become 12.70%.

b)

In this question, no mention of the cost of debt is there and nor the WACC for the first part is given. If these values were there, we would have found the WACC for the new owner as

WACC for new owner = (2/6) * (After-Tax Cost of Debt) + (4/6) * (12.70%) ------------------------------------ Equation 1

After finding this WACC, we would find the Present value of Cash inflows from the completion of the project.

Perpetuity Value = $575 / WACC for new owner

Present Value of Cash inflows = Perpetuity Value / ((1 + WACC) ^ 1)

NPV = Present Value of Cash inflows - Cash Outflows = Present Value of Cash Inflows - $ 7.15 billion

If NPV > 0 then the project would be viable for the new owner.

If NPV < 0 then the project would not be viable.

Thus there is a missing piece of information on cost of debt for the second part. If its put in Equation 1, then the whole part would be calculated.