Question

Books Inc. is a publicly traded publishing company. It has a current stock price of $75 per share and an equity beta of 0.8. Books is consistently profitable and faces a marginal tax rate of 21%. It also maintains a target leverage ratio of 40%. Books’ debt is AAA-rated and can be considered essentially risk free. The risk free rate in the economy is 5% and the market premium is 4%. You may assume that the CAPM holds.

Part 1: Books is considering a project that will expand its existing publishing business. The expansion would require an initial investment of $50 million dollars. It would produce annual free cash flows of $4 million, which would begin in one year and continue in perpetuity. What is the NPV of the investment project? (Please express your answer in millions of dollars, rounded to the nearest hundredth. For example, $100.569 million should be entered as $100.57.)

Part 2: What is the debt capacity created by the new investment project at the time it is initiated? (Please express your answer in millions of dollars, rounded to the nearest hundredth. For example, $100.569 million should be entered as $100.57.)

Part 3:Suppose that Books also has the opportunity to create an online division that will focus on digital distribution of content. Books believes that ultimately the business risk of this new venture is comparable to the business risk of its existing operations. However, the new division will have fewer tangible assets. So, Books would manage the division at a target leverage ratio of 20% instead of 40%. What is the business risk (i.e., LaTeX: \beta_{OA}β O A) of Books existing operations? (Please express your answer rounded to the nearest hundredth. For example 1.569 should be entered as 1.57.)

Part 4: What would be an appropriate opportunity cost of capital (or after-tax WACC) for Books to use to value free cash flows in its new online division? (You may assume that the cost of debt capital is the same for the online division as for the existing operations. Please express your answer as a percentage, rounded to the nearest hundredth. For example 10.569% should be entered as 10.57.)

Answer 1

	Rf	5%
	Rm-Rf	4%
	Beta	0.8
	CAPM	Rf+Beta*(Rm-Rf)
	Cost of equity	8.2%
Part 1)		Year0
	Initial Investment	(50,000,000)
	Annual FCF
	Perpetuity cash flows	48,780,488
	NPV (in Millions)	$                (1.22)
Part2)	As the company maintains a levrage ratio of 40%, and the new projet is funded by equity thus to maintain the ratio the company has to add more debt funding in the company
	Debt capacity added ( in millions)	20.00
Part3)	Business risk is the unleverd beta of the company
	Unleverd beta=levered beta/[1+(1-tax rate)&*Debt/Equity)]
	0.52	<--Business risk of the company

For part 4 we would require the cost of debt, as it is not mentioned in the question

WACC = wD*rD *(1-t) + wE*rE

1. w = the respective weight of debt and equity in the total capital structure.
2. t = tax rate.
3. D = cost of debt.
4. E = cost of equity

Pleasereach out for further clarification