Question

You are a consultant who has been hired to evaluate a new product line for Markum Enterprises. The upfront investment required to launch the product line is $7 million. The product will generate free cash flow of $0.70 million the first​ year, and this free cash flow is expected to grow at a rate of 6% per year. Markum has an equity cost of capital of 11.9%​, a debt cost of capital of 6.37%​, and a tax rate of 42%. Markum maintains a​ debt-equity ratio of 0.60.

a. What is the NPV of the new product line​ (including any tax shields from​ leverage)?

b. How much debt will Markum initially take on as a result of launching this product​ line?

c. How much of the product​ line's value is attributable to the present value of interest tax​ shields?

Answer 1

D/ E = 0.6

D = 0.6 * E

Weighted avergae cost of capital = Weight of Debt * Debt Cost * (1 - Tax rate) + Weight of Equity * Equity Cost

Weighted avergae cost of capital = D/ (D+E) * 6.37% * (1 - 42%) + E/(D + E) * 11.9%

Weighted avergae cost of capital = 0.6 * E/ (1.6 * E) * 6.37% * (1 - 42%) + E/(0.6 * E + E) * 11.9%

Weighted average cost of capital = 1.385% + 7.44%

Weighted average cost of capital = 8.82%

Value of project = 0.70/ (8.82% - 6%)

Value of project = 24.80 million

NPV = -7 + 24.80

NPV = 17.80 million

Part B

Debt to value ratio = .6/ 1.6 = 37.50%

Debt = 37.50% * 24.80 million

Debt = 9.30 million

Part C

Unlevered value:

Weighted avergae cost of capital = Weight of Debt * Debt Cost * + Weight of Equity * Equity Cost

Weighted avergae cost of capital = D/ (D+E) * 6.37% + E/(D + E) * 11.9%

Weighted avergae cost of capital = 0.6 * E/ (1.6 * E) * 6.37% + E/(0.6 * E + E) * 11.9%

Weighted average cost of capital = 2.39% + 7.44%

Weighted average cost of capital = 9.83%

Value of project = 0.70/ (9.83% - 6%)

Value of project = 18.29 million

Tax shield = 24.80 million - 18.29 million

Tax shield = 6.50 million