Question

The Birmingham Road Company (BRC) has won a tender to build a highway extension. The project will last 10 years and will generate free cash flows (FCFs) of £100 million per year for 10-years. These FCFs are after-tax but before financing costs. The unlevered (i.e., all equity) cost of capital for the project is 10% and BRC’s tax rate is 40%.

BRC will finance the project with a combination of debt and equity and is considering three alternatives as regards borrowing. The (pre-tax) interest rate in each case would be 5%. (Note: there are no tax consequences when the firm repays principal – as opposed to interest – on a loan).

1. “ConstantD/V”:Adjustingtheamountofborrowingeachyearsothattheratio of the amount of debt to the total value of the project is maintained at 40%; OR

2. “Constantamountofdebt”:Takingoutaconventional10-yearloan(i.e.,theloan will be repaid in year 10) with the amount of the loan equal to 40% of the unlevered value of the project; OR

3. “Amortizing Loan”: Taking out a 10-year amortizing loan, i.e., one in which equal payments are made each year so that the loan – including interest – is finally repaid in year 10. The amount of the loan will be equal to 40% of the unlevered value of the project.

Questions

1. What is the PV of the FCFs if the project is all equity financed?

2. What is the present value of the tax shields for borrowing scenario #1 (Constant D/V)?

3. What is the present value of the tax shields for borrowing scenario#2 (Constant amount of debt)?

4. What is the present value of the tax shields for borrowing scenario #3 (Amortizing Loan)?

5. Are these tax shields the same? If not, why not?

Answer 1