## Questions and Problems

Adjusted-Present-Value Approach

17.1 Honda and GM are competing to sell a fleet of cars to Hertz. Hertz's policies on its rental cars include use of straight-line depreciation and disposing of the cars after five years. Hertz expects that the autos will have no salvage value. The firm expects a fleet of 25 cars to generate $100,000 per year in pretax income. Hertz is in the 34-percent tax bracket, and the firm's overall required return is 10 percent. The addition of the new fleet will not add to the risk of the firm. Treasury bills are priced to yield 6 percent.

a. What is the maximum price that Hertz should be willing to pay for the fleet of cars?

b. Suppose the price of the fleet (in U.S. dollars) is $325,000; both suppliers are charging this price. Hertz is able to issue $200,000 in debt to finance the project. The bonds can be issued at par and will carry an 8-percent interest rate. Hertz will incur no costs to issue the debt and no costs of financial distress. What is the APV of this project if Hertz uses debt to finance the auto purchase?

c. To entice Hertz to buy the cars from Honda, the Japanese government is willing to lend Hertz $200,000 at 5 percent. Now what is the maximum price that Hertz is willing to pay Honda for the fleet of cars?

17.2 Peatco, Inc., is considering a $2.1 million project that will be depreciated according to the straight-line method over the three-year life of the project. The project will generate pretax earnings of $900,000 per year, and it will not change the risk level of the firm. Peatco can obtain a three-year, 12.5-percent loan to finance the project; the bank will charge Peatco flotation fees of 1 percent of the gross proceeds of the loan. The fee must be paid up front, not from the loan proceeds. If Peatco financed the project with all equity, its cost of capital would be 18 percent. The tax rate is 30 percent, and the risk-free rate is 6 percent.

a. Using the APV method, determine whether or not Peatco should undertake the project.

b. After hearing that Peatco would not be initiating the project in their town, the city council voted to subsidize Peatco's loan. Under the city's proposal, Peatco will pay the same flotation costs, but the rate on the loan will be 10 percent. Should Peatco accept the city's offer and begin the project?

17.3 MEO Foods, Inc., has made cat food for over 20 years. The company currently has a debt-equity ratio of 25 percent, borrows at a 10-percent interest rate, and is in the 40-percent tax bracket. Its shareholders require an 18-percent return.

MEO is planning to expand cat food production capacity. The equipment to be purchased would last three years and generate the following unlevered cash flows (UCF):

Unlevered Cash Flows by Year (in $ millions)

MEO has also arranged a $6 million debt issue to partially finance the expansion. Under the loan, the company would pay 10 percent annually on the outstanding balance. The firm would also make year-end principal payments of $2 million per year, completely retiring the issue at the end of the third year.

Ignoring costs of financial distress and issue costs, should MEO proceed with the expansion plan?

17.4 Roller and Decker Corp. has established a joint venture with Malaysia Road Construction Company to build a toll road in Malaysia. The initial investment in paving equipment is $20 million. Straight-line depreciation will be used, and the equipment has an economic life of five years with no salvage value. The annual construction costs are estimated to be $10 million. The project will be finished in two years. Net toll revenue collected from the usage of the road is projected to be $6 million per annum for 20 years starting from the end of the first year of usage. The local preferential corporate tax rate for joint ventures is

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25 percent. There are no other taxes. The required rate of return for the project under all-equity financing is 12 percent. The prevailing market interest rate is 9 percent a year. To encourage foreign capital participation in the infrastructure sector, the Malaysian government will subsidize the project with $10 million of a 15-year, long-term loan, at an interest rate of 5 percent a year. What is the NPV of this project?

### Flow-to-Equity Approach

17.5 Milano Pizza Club owns a chain of three identical restaurants popular for their Milan style pizza. Comparable stores have an equity value of $900,000 and debt-to-equity ratio of 30 percent. The prevailing market interest rate is 9.5 percent. An equivalent all-equity-financed store would have a discount rate of 15 percent. For each Milano store, the estimated annual sales are $1,000,000, costs of goods sold $400,000, and general and administrative costs $300,000. (Every cash flow stream is assumed to be a perpetuity.) The marginal tax rate is 40 percent. What is the value of the Milano Pizza Club?

### Weighted-Average-Cost-of-Capital Approach

17.6 The overall firm beta for Wild Widgets, Inc., (WWI) is 0.9. WWI has a target debt-equity ratio of 1/2. The expected return on the market is 16 percent, and Treasury bills are currently selling to yield 8 percent. WWI one-year bonds that carry a 7-percent coupon are selling for $972.72. The corporate tax rate is 34 percent.

a. What is WWI's cost of equity?

b. What is WWI's cost of debt?

c. What is WWI's weighted average cost of capital?

17.7 Value Company has compiled the following information on its financing costs:

Type of Book Market Before-Tax

Financing Value Value Cost

Short-term debt 5,000,000 5,000,000 8

Common stock 10,000,000 13,000,000 15

Total $20,000,000 $20,000,000

Value is in the 34-percent tax bracket and has a target debt-equity ratio of 100 percent. Value's managers would like to keep the market values of short-term and long-term debt equal.

a. Calculate the weighted average cost of capital for Value Company using i. Book-value weights ii. Market-value weights iii. Target weights b. Explain the differences between the WACCs. What are the correct weights to use in the WACC calculation?

17.8 Baber Corporation's stock returns have a covariance with the market of 0.031. The standard deviation of the market returns is 0.16, and the historical market premium is 8.5 percent. Baber bonds carry a 13-percent coupon rate and are priced to yield 11 percent. The market value of the bonds is $24 million. Baber stock, of which 4 million shares are outstanding, sells for $15 per share. Baber's CFO considers the firm's current debt-equity ratio optimal. The tax rate is 34 percent, and the Treasury bill rate is 7 percent.

Baber Corp. must decide whether to purchase additional capital equipment. The cost of the equipment is $27.5 million. The expected cash flows from the new equipment are $9 million a year for five years. Purchasing the equipment will not change the risk level of Baber Corp. Should Baber purchase the equipment?

17.9 National Electric Company (NEC) is considering a $20 million modernization expansion project in the power systems division. Tom Edison, the company's chief financial officer, has evaluated the project; he determined that the project's after-tax cash flows will be $8 million, in perpetuity. In addition, Mr. Edison has devised two possibilities for raising the necessary $20 million:

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17. Valuation and Capital Budgeting for the Levered Firm

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Part IV Capital Structure and Dividend Policy

NEC's cost of debt is 10 percent, and its cost of equity is 20 percent. The firm's target debt-equity ratio is 200 percent. The expansion project has the same risk as the existing business, and it will support the same amount of debt. NEC is in the 34-percent tax bracket.

Mr. Edison has advised the firm to undertake the expansion. He suggests they use debt to finance the project because it is cheaper and its issuance costs are lower.

a. Should NEC accept the project? Support your answer with the appropriate calculations.

b. Do you agree with Mr. Edison's opinion of the expense of the debt? Why or why not?

### 17.10 Refer to question 17.8.

Baber Corporation has chosen to purchase the additional equipment. If Baber funds the project entirely with debt, what is the firm's weighted average cost of capital? Explain your answer.

A Comparison of the APV, FTE, and WACC Approaches

17.11 ABC, Inc., is an unlevered firm with expected perpetual annual before-tax cash flows of $30 million and required return on equity of 18 percent. It has 1 million shares outstanding. ABC is paying tax at a marginal rate of 34 percent. The firm is planning a recapitalization under which it will issue $50 million of perpetual debt bearing a 10-percent interest rate and use the proceeds to buy back shares. Calculate the post-recap share price, earnings per share, and required return on equity.

17.12 Kinedyne, Inc., has decided to divest one of its divisions. The assets of the group have the same operating risk characteristics as those of the parent firm. The capital structure for the parent has been stable at 40-percent debt/60-percent equity (in market-value terms), the level determined to be optimal given the firm's assets. The required return on Kinedyne's assets is 16 percent, and the firm (and the division) borrows at a rate of 10 percent.

Sales revenue for the division is expected to remain stable indefinitely at last year's level of $19,740,000. Variable costs amount to 60 percent of sales. Annual depreciation of $1.8 million is exactly matched each year by new investment in the division's equipment. The division would be taxed at the parent's current rate of 40 percent.

a. How much is the division worth in unleveraged form?

b. If the division had the same capital structure as the parent firm, how much would it be worth?

c. At this optimal capital structure, what return will the equityholders of the division require?

d. Show that the market value of the equity of the division would be justified by the earnings to shareholders and the required return on equity.

17.13 Folgers Air Transport (FAT) is currently an unleveraged firm. It is considering a capital restructuring to allow $500 in debt. The company expects to generate $151.52 in cash flows before interest and taxes, in perpetuity. Its cost of debt capital is 10 percent and the corporate tax rate is 34 percent. Unleveraged firms in the same industry have a cost of equity capital of 20 percent.

Capital Budgeting for Projects That Are Not Scale-Enhancing

17.14 Schwartz & Brothers Inc. is in the process of deciding whether to make an equity investment in a project of holiday gifts production and sales. Arron Buffet is in charge of the feasibility study of the project. To better assess the risk of the project, he used the average of 10 other firms in the holiday gift industry with similar operational scales as the benchmark. The figures that he has are as follows:

Using WACC, APV, and FTE, what will be the new value of FAT?

Project Benchmark

Debt-equity ratio ß

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Corporate Finance, Sixth Dividend Policy Budgeting for the Levered Companies, 2002

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Chapter 17 Valuation and Capital Budgeting for the Levered Firm 489

The expected market return is 17 percent, and the risk-free interest rate is 9 percent. Corporate tax rate is 40 percent. The initial investment in the project is estimated at $325,000, and the cash flow at the end of the first year is $55,000. Annual cash flow will grow at a constant rate of 5 percent till the end of the fifth year and remain constant forever thereafter. Should Schwartz & Brothers invest in this project (assume that the bond beta is zero)?

### APV Example

17.15 Brenda Lynch, CFO of Hunter Enterprises, is evaluating a 10-year, 9-percent loan. The projected net proceeds after flotation costs to be raised by the loan are $4,250,000. The flotation costs are estimated to be 1.25 percent of the gross proceeds and will be amortized using a straight-line schedule over the life of the loan. The cost of similar debt is 9.4 percent. The applicable corporate tax is 40 percent. Suppose that the loan will not increase the financial distress cost of the firm. What is the net present value of this loan?

### Beta and Leverage

17.16 North Pole Fishing Equipment Corp. and South Pole Fishing Equipment Corp. would have identical P of 1.2 if both of them were all-equity financed. The capital structures of the two firms are as follows:

North Pole Fishing South Pole Fishing Equipment Corp. Equipment Corp.

Equity 1,500,000 1,000,000

The expected market rate of return is 12.75 percent, and the three-month Treasury bill rate is 4.25 percent. Corporate tax rate is 35 percent (assume that bond beta is zero).

a. What are the Ps of the two firms, respectively?

b. What are the required rates of return on the two firms' equity?

c. Try to give an intuitive explanation of the different Ps and the returns on equity obtained in parts (a) and (b).

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