Question

Question 1

The flow-to-equity approach has been used by the firm to value their capital budgeting projects. The total investment cost at time 0 is $640,000. The company uses the flow-to-equity approach because they maintain a target debt to value ratio over project lives. The company has a debt to equity ratio of 0.5. The present value of the project including debt financing is $810,994. What is the relevant initial investment cost to use in determining the value of the project?

Question 2

The Gold Paving Co. has an equity cost of capital of 16.97%. The debt to value ratio is .6, the tax rate is 34%, and the cost of debt is 11%. What is the cost of equity if Tip-Top was unlevered?

Question 3

The Company is in the 36% tax bracket, has riskless debt which makes up 40% of the total capital structure, and equity is the other 60%. The beta of the assets for this business is .8 and the equity beta is: _____________

Question 4

The Azzam Oil Company is considering a project that will cost $50 million and have a year-end after-tax cost savings of $7 million in perpetuity. Azzam's before tax cost of debt is 10% and its cost of equity is 16%. The project has risk similar to that of the operation of the firm, and the target debt-equity ratio is 1.5. What is the NPV for the project if the tax rate is 34%?

Answer 1

1. Given, D/E = 0.5

Adding 1 to both sides,

D/E + 1 = 1.5

(D+E)/E = 1.5

V/E = 1.5/1

E/V = 1/1.5 = 0.67

D/V = 1- E/V = 1-0.67 = 0.33

Value of project including debt financing = $810,994

Debt Financing/Value = 0.33

Debt financing = 0.33*$810,994 = $267,628.02

Total investment cost = $640,000

Thus, initial investment cost for valuing the project = $640,000 - $267,628.02 = $372,372

2. Cost of equity, Ke = 16.97%

D/V = 0.6

Tax rate, t = 34%

Cost of debt, Kd = 11%

D/V = 0.6

E/V = 1-0.6 = 0.4

D/E = 0.6/0.4 = 1.5

Levered cost of equity = Unlevered cost of equity + (Unleverd cost of equity - Cost of debt)*D/E

16.97% = Unlvered cost of equity + (Unleverd cost of equity - 11%)*1.5

Unlevered cost of equity = (16.97% + 16.5%)/2.5 = 14%

3. Asset beta = 0.8

D/E = 40%/60% = 2/3

Tax = 36%

Equity beta = Asset Beta*(1 + D/E( 1-Tax)

= 0.8*(1+2/3*(1-36%) = 1.14

4. Cost of project = $50 million

Cost savings in perpetuity = $7 million

Kd = 10%

Ke = 16%

t = 34%

D/E = 1.5

V/E = 2.5

E/V = 40%

D/V = 1-40% = 60%

WACC = 40%*16%+60%*10%*(1-34%) = 10.36%

Thus, present value of savings = Savings per year/wacc = $7 million/10.36% = $67567568

NPV = $67567568 - $50 million = $17567568