Question

Acme is considering a new project that requires an investment of $100 million in machinery. This is expected to produce earnings before interest and taxes of $16 million per year for 4 years. The machinery will be fully depreciated to a zero-book value over 4 years using straight-line depreciation. Working capital costs are negligible. The tax rate is 25%. The unlevered cost of capital is 13%. They have a target debt ratio (debt/value) for the firm of 45%. Joker plans to use $40 million in bonds. The remaining funds will come from retained earnings. The bonds have a 4-year life, a coupon rate of 5% and a yield of 5%. Use free cash flows to equity to find the value of the project. You do NOT need to rebalance the debt (assume it is interest only debt for 4 years).

FCFE for year 0 =

FCFE for each year 1 to 3 =

FCFE for year 4 =

Value of the project =

Answer 1

Cost of machine = $ 100 million

Life of machine = 4 years

Salvage = 0

Depreciation (SLM) = (Cost of machine - Salvage)/ Life of machine

= $ 100 million / 4 years

= $ 25 million

Interest on bonds = $ 40 million * 5%

= $ 2 million

FCFE for year 0 = - $ 60 million

FCFE for each year 1 to 3 = $ 35.50 million

FCFE for year 4 = -$ 4.50 million

Value of the project = -$60.00 million + $31.42 million + $27.80 million + $24.61 million - $2.76 million

= $ 21.06 million

Note: FCFE denotes free cash flows available for equity.

Note: Discounting factor has been rounded off to four decimal places.