Question

Mango Plc. is a computer and personal electronics manufacturer. It is an all equity firm, it has 1 billion shares outstanding, each priced at $300, and has an equity beta of 1.5. Assume that the risk-free rate is 2%, the market risk-premium is 5%, the CAPM holds, and the marginal tax rate is 30%.

a) Considering investing in new project with $10 billion initial investment and annual, unlevered free cash-flows of $2 billion for the next 25 years (starting a year from now). Should they invest in the project, assuming that it is in the same line of interest with their existing assets? (ignoring any financing effects)

b) They realize they can finance by issuing debt, and take advantage of tax shields. They expect to raise at 4% cost of capital while maintaining (D/E) ratio of 1.5 for lifetime of project. How much additional value does this add to Mango?

Answer 1

Cost of Equity using CAPM = Risk free rate + (Beta*market risk-premium)

= 2%+(1.5*5) = 9.5%

a) NPV of this project is positive. Hence we can recommend to invest in the project, assuming that it is in the same line of interest with their existing assets.

We need to discount free cash-flows of $2 billion for the 25 years to know the PV of cash-flows of the new project.

Using BA II plus financial calculator, we can calculate the PV as follows.

Enter N=25, I/Y = 9.5, FV=0, PMT=2 billion , PV=18.875 billion

Hence, NPV= 18.875 billion - 10 billion initial investment = 8.875 billion.

b) Additional value added to Mango is 8.005 billion. If company is using Debt, its overall cost of capital decreases and firm value increases. We now discount Project cash flows using overall cost of capital i.e., WACC.

WACC = [Weight of Debt*cost of capital of debt*(1-Tax rate)] + [Weight of equity* Cost of Equity]

To calculate WACC, we need Market value Weights of Debt and Equity.

(D/E) ratio of 1.5 means,

Debt = 1.5 (60%)

Equity = 1 (40%)

Total capital = 2.5 (100%)

WACC = [0.6*4%*(1-0.3)]+[0.4*9.5%]

= 1.68%+3.8% = 5.48%

Now again we need to discount free cash-flows of $2 billion for the 25 years to know the PV of cash-flows with WACC.

Using BA II plus financial calculator, we can calculate the PV as follows.

Enter N=25, I/Y = 5.48, FV=0, PMT=2 billion , PV=26.880 billion

Hence, NPV= 26.880 billion - 18.875 billion = 8.005 billion.