In: Finance
NeoDiagnostic is an all-equity firm with 10,000 shares on the
issue currently selling for $25.36 each. The CAPM beta coefficient
for NeoDiagnostic's (currently unlevered) equity is 1.6, while the
riskless interest rate is 1.25% and the market risk premium is
5.75%. After share trading for the day ceases, NeoDiagnostic
announces a new project to manufacture a "breakthrough product"
arising from its just-completed R&D program. The project will
require it to invest $1.25 million. The investment can be
depreciated on a straight-line basis over 10 years, with the first
allowance available one year from today. NeoDiagnostic uses the
riskless interest rate to discount the associated depreciation tax
shield.
The project is expected to produce before-tax operating cash flow
equal to $237,000 at the end of the first year, growing at 4%
annually for each of the following 3 years, then remaining constant
for the following 6 years, at which point the project ends. The
corporate tax rate is 21%. When announcing the project,
NeoDiagnostic also announced that it intends to borrow $750,000 at
an interest rate of 6% per annum to partially finance the project.
Remaining funds needed for the investment will be raised through a
new equity issue. The debt will be retired in full at the
conclusion of the project in 10 years from now. Assume that the
corporate tax effect of debt approximates the overall effect of
debt on firm market value. NeoDiagnostic believes that the new
project will not alter investor's perceptions of the fundamental
risks for the company's business.
(a) Use the APV approach to levered valuation to calculate the NPV
of this investment project.
(b) What should happen to the price of the company's stock upon announcement of the investment project and associated financing mechanism?
(c) How many shares would have to be floated to finance the investment?
(d) Write down the market value balance sheet immediately before the project and associated financing mechanism is announced.
Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Year 6 | Year 7 | Year 8 | Year 9 | Year 10 | Remark | |
Investment | (1,250,000) | ||||||||||
depreciation Tax Shied | (26,250) | (26,250) | (26,250) | (26,250) | (26,250) | (26,250) | (26,250) | (26,250) | (26,250) | (26,250) | " 1.25 Mn / 10 years x Tax" |
Debt Raised / repaid | 750,000 | - | - | - | - | - | - | - | - | (750,000) | |
Interest | (45,000) | (45,000) | (45,000) | (45,000) | (45,000) | (45,000) | (45,000) | (45,000) | (45,000) | (45,000) | |
Cashflow (without Tax) | 237,000 | 246,480 | 256,339 | 266,593 | 266,593 | 266,593 | 266,593 | 266,593 | 266,593 | 266,593 | |
"Growth of 4%" | "Growth of 4%" | "Growth of 4%" | "Same as LY" | "Same as LY" | "Same as LY" | "Same as LY" | "Same as LY" | "Same as LY" | |||
Cashflow after Interest | 192,000 | 201,480 | 211,339 | 221,593 | 221,593 | 221,593 | 221,593 | 221,593 | 221,593 | 221,593 | |
depreciation | (125,000) | (125,000) | (125,000) | (125,000) | (125,000) | (125,000) | (125,000) | (125,000) | (125,000) | (125,000) | |
Profit before tax | 67,000 | 76,480 | 86,339 | 96,593 | 96,593 | 96,593 | 96,593 | 96,593 | 96,593 | 96,593 | |
Tax | 14,070 | 16,061 | 18,131 | 20,284 | 20,284 | 20,284 | 20,284 | 20,284 | 20,284 | 20,284 | |
PAT | 52,930 | 60,419 | 68,208 | 76,308 | 76,308 | 76,308 | 76,308 | 76,308 | 76,308 | 76,308 | |
a. | The Adjusted Present Value (APV) is the net present value (NPV) approach where cost of equity is used for discounting the cashflow with taking any impact of Debt funding. Then, impact of Debt is saperatly added to the project with tax benfit. | ||||||||||
Cashflow to equity | 237,000 | 246,480 | 256,339 | 266,593 | 266,593 | 266,593 | 266,593 | 266,593 | 266,593 | 266,593 | PBT + Depreciation + Interest |
Investment | (1,250,000) | ||||||||||
Cost of Equity | 10.5% | ||||||||||
NPV | $1,137,136 | ||||||||||
Debt Raised / repaid | 750,000 | - | - | - | - | - | - | - | - | (750,000) | |
Interest | (45,000) | (45,000) | (45,000) | (45,000) | (45,000) | (45,000) | (45,000) | (45,000) | (45,000) | (45,000) | |
Tax | (14,070) | (16,061) | (18,131) | (20,284) | (20,284) | (20,284) | (20,284) | (20,284) | (20,284) | (20,284) | |
depreciation Tax Shied | (26,250) | (26,250) | (26,250) | (26,250) | (26,250) | (26,250) | (26,250) | (26,250) | (26,250) | (26,250) | |
Total Benefit of tax and debt | 664,680 | (87,311) | (89,381) | (91,534) | (91,534) | (91,534) | (91,534) | (91,534) | (91,534) | (841,534) | |
NPV | ($373,521) |
Related SolutionsAshman Motors is currently an all-equity firm. It has two million shares outstanding, selling for $37...Ashman Motors is currently an all-equity firm. It has two
million shares outstanding, selling for $37 per share. The
company has a beta of 0.9, with the current risk-free rate at
3.1% and the market premium at 7.6%. The tax rate is 25% for the
company. Ashman has decided to sell $37 million of bonds and
retire half its stock. The bonds will have a yield to maturity of
7.4%. The beta of the company will rise to 1.3 with...
Adjusted WACC. Thorpe and Company is currently an all-equity firm. It has three million shares selling...Adjusted WACC. Thorpe and Company is
currently an all-equity firm. It has three million shares selling
for $22 per share. Its beta is 0.7, and the current risk-free
rate is 2.3%. The expected return on the market for the coming
year is 10.6%. Thorpe will sell corporate bonds for $22,000,000
and retire common stock with the proceeds. The bonds are
twenty-year semiannual bonds with a 9.3% coupon rate and 1,000 par
value. The bonds are currently selling for $923.83 per...
Adjusted WACC. Thorpe and Company is currently an all-equity firm. It has three million shares selling...Adjusted WACC. Thorpe and Company is currently an all-equity
firm. It has three million shares selling for $40 per share. Its
beta is 1.4, and the current risk-free rate is 3.5%. The
expected return on the market for the coming year is 13.4%. Thorpe
will sell corporate bonds for $40,000,000 and retire common stock
with the proceeds. The bonds are twenty-year semiannual bonds with
a 8.6% coupon rate and $1,000 par value. The bonds are currently
selling for $1,135.64 per...
Q1. An all-equity financed firm has 1 million shares outstanding, currently selling at $10 per share....Q1. An all-equity financed firm has 1 million shares
outstanding, currently selling at $10 per share. It considers a
restructuring that would issue $4 million in debt to repurchase
400,000 shares. How does this affect overall firm
value?
Q2: What is the expected return on equity for a firm
with a 14% expected return on assets that pays 9% on its debt,
which totals 30% of assets?
Q3: What is the expected rate of return to shareholders
if the firm...
Roger Inc. is currently an all equity firm that has 500,000 shares of stock outstanding at...
Roger Inc. is currently an all equity firm that has 500,000
shares of stock outstanding at a market price of $20 a share. EBIT
is $1,500,000 and is constant forever. The required annual rate of
return on the share is 12%. The corporate tax is 35%. The firm is
proposing borrowing an additional $2 million in debt and uses the
proceeds to repurchase stock. If it does so, the cost of debt will
be 10%. What will be the WACC...
Roger Inc. is currently an all equity firm that has 500,000 shares of stock outstanding at...
Roger Inc. is currently an all equity firm that has 500,000
shares of stock outstanding at a market price of $20 a share. EBIT
is $1,500,000 and is constant forever. The required annual rate of
return on the share is 12%. The corporate tax is 35%. The firm is
proposing borrowing an additional $2 million in debt and uses the
proceeds to repurchase stock. If it does so, the cost of debt will
be 10%. What will be the WACC...
4. Clarkson Corporation is currently an all equity firm that has 450,000 shares of stock outstanding...4. Clarkson Corporation is currently an all equity firm that has
450,000 shares of stock outstanding with a market price of $52.40 a
share. The current cost of equity is 10.5 percent and the tax rate
is 25 percent. The firm is considering adding $6.3 million of debt
with a coupon rate of 6 percent to its capital structure. The debt
will be sold at par value. What is the levered value of the
equity?
a
$18,855,000
b
$19,247,000
c...
Gail's Dance Studio is currently an all equity firm that has 80,000 shares of stock outstanding...Gail's Dance Studio is currently an all equity firm that has
80,000 shares of stock outstanding with a market price of $42 a
share. The current cost of equity is 12% and the tax rate is 34%.
Gail is considering adding $1 million of debt with a coupon rate of
8% to her capital structure. The debt will be sold at par value.
What is the levered value of the equity?
i have the answer for this question. it was:...
?Zelnor, Inc., is an? all-equity firm with 180 million shares outstanding currently trading for $ 11.52...?Zelnor, Inc., is an? all-equity firm with 180 million shares
outstanding currently trading for $ 11.52 per share. Suppose Zelnor
decides to grant a total of 18 million new shares to employees as
part of a new compensation plan. The firm argues that this new
compensation plan will motivate employees and is better than giving
salary bonuses because it will not cost the firm anything. Assume
perfect capital markets. a. If the new compensation plan has no
effect on the...
Kurz Manufacturing is currently an all-equity firm with 3535 million shares outstanding and a stock price...
Kurz Manufacturing is currently an all-equity firm with
3535
million shares outstanding and a stock price of
$ 11.50$11.50
per share. Although investors currently expect Kurz to remain
an all-equity firm, Kurz plans to announce that it will borrow
$ 45$45
million and use the funds to repurchase shares. Kurz will pay
interest only on this debt, and it has no further plans to
increase or decrease the amount of debt. Kurz is subject to a
38 %38%
corporate tax...
ADVERTISEMENT
ADVERTISEMENT
Latest Questions
ADVERTISEMENT
|