Question

In: Finance

You are evaluating a 1-year project that is in line with the firm’s existing business. Specifically,...

You are evaluating a 1-year project that is in line with the firm’s existing business. Specifically, this new project requires an investment of $1,200 in free cash flow today, but will generate $1,600 one year from today. The project will be partially financed with a 1-year maturity debt whose face value is $200 and interest rate is 10%.

Suppose that you estimated the cost of equity as 20%, based on the firm’s stock data. However, you were not able to estimate the cost of debt because your firm’s total debt consists of long-term debt, short-term debt, investment grade debt, and debt with different levels of collateral. Assume that the corporate tax rate is 30%.

What is the effective after-tax interest expense at year 1?

A.

$21
B.

$155
C.

$14
D.

$80

What is the net borrowing (i.e. net debt issuance) at year 0? What is the net borrowing at year 1?

A.

-$200; $200
B.

$200; $200
C.

$200; -$200
D.

-$200; -$200

What is the free cash flow to equity (FCFE) at year 0 (i.e. today)? (Hint: Since you just issued the debt, the interest payment at time 0 is simply zero.)

A.

$1,000
B.

-$1,386
C.

$1,386
D.

-$1,000

What is the FCFE at year 1?

A.

$1,386
B.

-$1,386
C.

-$1,000
D.

$1,000

Under the FTE approach, the NPV of the project is obtained by discounting future FCFE using the _______.

A.

Cost of levered equity
B.

Cost of assets
C.

Weighted average cost of capital
D.

Cost of unlevered equity

What is the NPV of this project?

A.

$155
B.

$14
C.

$80
D.

$21

Solutions

Expert Solution

PT 1

Effective after tax = Interest* (1- Tax rate)

                                 =(200*10%)*(1-0.3) i.e.$14 option c

PT 2

Net borrowing at year 0 is $200 since cash flow is received

Net borrowing at year 1 is -$200 since loan is repaid.

So option c is correct

PT3

FCFE at year 0 = Borrowing – Investment

                           =200-1200 i.e. -$1000 option D

PT4

FCFE at year 1 = Cash flow generated –Borrowing repaid – Interest expenses after tax

                           =1600-200-14 i.e. $1386 option A

jeff jeffy answered 1 year ago
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