Question

You are a consultant who was hired to evaluate a new product line for Gupta Enterprises. The upfront investment required to launch the product is $ 5 million. The product will generate free cash flow of $ 0.74 million the first​ year, and this free cash flow is expected to grow at a rate of 4 % per year. Gupta has an equity cost of capital of 10.7 %​, a debt cost of capital of 5.14 %​, and a tax rate of 42 %. Gupta maintains a​ debt-equity ratio of 0.90. a. What is the NPV of the new product line​ (including any tax shields from​ leverage)? b. How much debt will Gupta 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? a. What is the NPV of the new product line​ (including any tax shields from​ leverage)? The NPV of the new product line is ​$ nothing million.  ​(Round to two decimal​ places.) b. How much debt will Gupta ,initially take on as a result of launching this product​ line? Debt will be ​$ nothing million.  ​(Round to two decimal​ places.) c. How much of the product​ line's value is attributable to the present value of interest tax​ shields? The amount of the product​ line's value that is attributable to the present value of interest tax shields is ​$ nothing million.  ​(Round to two decimal​ place

Answer 1

Initial Investment = 5 million

Cost of Debt = 5.14%

Cost of Equity = 10.7%

Debt Equity Ratio = 0.90 = 9/10

Weight of Debt = 9/19

Weight of Equity = 10/19

WACC = (Cost of Debt * Weight of Debt * (1 - Tax rate)) + (Cost of Equity * Weight of Equity)

WACC = (5.14% * 9/19 * (1 - 0.42)) + (10.7% * 10/19)

WACC = (1.41%) + (5.63%)

WACC = 7.04%

Value of Product = 0.74 million/ (WACC - Growth Rate)

Value of Product = 0.78 million/ (7.04% - 4%)

Value of Product = 24.33 million

NPV = -5 million + 24.33 million

NPV = 19.33 million

Part B:

Debt-to-Value ratio is = (0.9) / (1.9) = 47.38%.

Debt will be = 47.38% × $24.33 million = $11.52 million

Part C:

We will first find unlevered discount rate:

WACC = (Cost of Debt * Weight of Debt) + (Cost of Equity * Weight of Equity)

WACC = (5.14% * 9/19) + (10.7% * 10/19)

WACC = (2.43%) + (5.63%)

WACC = 8.066%

Value of Product = 0.74 million/ (WACC - Growth Rate)

Value of Product = 0.74 million/ (8.066% - 4%)

Value of Product = 18.20 million

Tax shield value is therefore = 24.33 million - 18.20 million = $6.13 million