Question

Salo inc. has assets in place that are financed through debt for $245,000,000 and equity for $53,000,000. At the moment the return on equity is 15% and the company keeps a constant debt-to-equity policy. The company plans to start a new project that will be managed separately from the other company's operations. The project has a 5-year life. The company needs to acquire new assets for $45,000,000. The company thinks to adopt a constant debt policy for this project and plans to raise a debt amount that is 1.4 the raised equity. In order to raise financial resources for the new project, Salo uses as lead underwriter Lindberg Bank, which charges a 3.6% spread to raise equity, and a 0% spread to raise debt. The new project will produce a constant expected net income of $2,500,000, the depreciation tax shield is as risky as the company's debt, while the project's assets are as risky as the company's assets in place. Also, the newly acquired assets will be depreciated straight-line. The corporate tax rate is 32% and the company can borrow at an interest rate of 3.55%.

(a) Calculate the new project's initial (time 0) cash flow, taking into account all side effects (that is, issuance costs).

(b) What is the annual after-tax cash flow from assets from the new project at the end of each of the five years of its life?

(c) Knowing that the depreciation tax shield is as risky as the company's debt, what is the project's NPV?

Answer 1

The net proceeds of the issue must be $ 45000000

so, let the equity raised be $ x,then,

x+1.4x= 45000000

Solving the above,

x=Equity raised=18750000

So, debt= 45000000-18750000=

26250000

$ Equity, net of spread=

18750000*(1-3.6%)=

18075000

SO,

(a)The new project's initial (time 0) cash flow, taking into account all side effects (that is, issuance costs)=

18075000+26250000=

44325000

(b)Annual after-tax cash flow from assets from the new project at the end of each of the five years of its life
Annual after-tax net income	2500000*(1-32%)=	1700000
Annual depn. Tax shield	45000000/5*32%=	2880000
Total annual after-tax cash flow from assets		4580000

c. Project's NPV
Calculation of WACC to dsicount cash flows:
Funding	ratio/wts. to total		Cost	Wt.* Cost
Equity	1	41.67%	15%	6.25%
Debt	1.4	58.33%	2.41%	1.41%
Total	2.4	100.00%		7.66%
NPV= -44325000+(4580000*(1-1.0766^-5)/0.0766)=
-25873340