In: Finance
Joe Exotic Inc. is considering expanding into the cruise line business. To finance the expansion project, Joe Exotic will issue a 3-year, zero coupon bond with face value of $500 million for $450.97 million. Joe’s consultants have analyzed the cruise line market and produced the following scenarios for the expansion project for each of the next three years:
Probability |
EBIT | Depreciation | CapEx | |
High | .35 | 750 | 50 | 50 |
Medium |
.35 | 500 | 50 | 50 |
Low | 0 | 0 | 50 | 50 |
Joe’s consultants have determined that the unlevered cost of capital in the cruise line industry is 6%. The expected return on the market portfolio is 4.75% and the risk-free rate is 1.50%. Joe Exotic Inc. has a D/E ratio of 0.75 and is subject to a 35% corporate tax. (Note: When EBIT is less than debt interest, a firm is unable to get a tax deduction.)
a) Use the APV approach to evaluate Joe’s expansion project. Should Joe Exotic invest into the cruise line business if the initial cost is $800 million?
b) List three scenarios in which you would prefer to use the APV approach over the WACC approach.
Note: Show your work in detail
Joe Exotic Inc. is considering expanding into the cruise line business and as per the analysis done by the Consultant the new line of business is expected to give the following cashflows under different scenarios.
Probability |
EBIT | Depreciation | CapEx | |
High | .35 | 750 | 50 | 50 |
Medium |
.35 | 500 | 50 | 50 |
Low | 0 | 0 | 50 | 50 |
As per this estimate the expected cashflow for the company is,
.High = .35(750-50-50) * (1-.35) + .35 * 50 = ,35 * 650 * .65 + .35 * 50 = 147.87 + 17.5 = 165.4 mn $
Medium = .35(500-50-50) * (1-.35) + .35 * 50 = .35 * 400 * .65 + .35 * 50 = 91 + 17.5 = 129.5 mn $
Low 0
Expected annual cash flow = 165.4 + 129.5 = 294.9 mn $
To finance the expansion project, Joe Exotic plans to issue a 3-year, zero coupon bond with face value of $500 million for $450.97 million
The yield on the bond = RATE(3,0,450.97,-500) = .04 or 4%
So the company would need to pay an annual interest of 500 * .04 = 20 mn $
However the company will be to get a tax shield on the interest for an amount = 20 * .35 = 7 mn $
So the net cashflow after interest = 294.9 - 20 + 7 = 281.9 mn $
The unlevered cost of capital for the cruise line industry is 6%
Hence the NPV of the cashinflows = 281.9 + 281.9/(1+.06) + 281.9/{(1+.06)^2}
= 281.9 + 265.9 + 250.8 = 798.6 mn $
a) Joe Exotic needs to invest 800 mn $ as initial investment and hence the NPV is = 798.6 - 800 = -1.4 mn $
Since the NPV of the investment is negative Joe Exotic should not make investment in this project.
b) APV approach considers the tax benefit from a dollar debt value based upon existing debt. But the cost of capital approach estimates the tax benefit from a debt ratio that may require the firm to borrow increasing amounts in the future. So in situations where any incremental borrowing would change debt ratio APV method is preferred as this method treats the firm as unlevered while calculating the cash flows and then measures the incremental impact of the any additional debt in the form of tax shields
Also APV approach leads to more accurate assessment for any project since it treats the effect of any leverage on an individual basis compared to overall cost of capital. A firm can get debt funding for different projects at different rates based on the risk profile of the project and APV method takes that into consideration. The overall debt to equity ratio of the firm might not reflect this properly.
If a project is fully funded by debt then the APV method will be more suited compared to the WACC approach.