Question C3 An aeroplane manufacturer can invest in a research and development p

Question

Question C3 An aeroplane manufacturer can invest in a research and development project that is aimed to improve the fuel efficiency of its planes. This project requires an initial expense of £1,000,000 and is expected to generate a payoff of £4,500,000 next year. The appropriate after-tax cost of capital for this project is 15%. The company has to pay taxes on this profits at the rate of 25%. Answer the following questions, showing all relevant calculations. (i) Assuming that the project is 100% equity financed, calculate the present value (PV) of the firm (25%) Assume now that the firm finances the project by borrowing £600,000 at a cost of debt of 7.5%, and the remainder with equity. Calculate the PV of the company using the Adjusted Present Value (APV) method under this alternative capital structure. (1) (25%) (iii) what is the adjusted WACC of this airline in the presence debt? (10%) In a different scenario the cost of debt (E(m)) for this airline is given by E(b) 1090 × w, where WD equals the debt-to-firm value ratio. What would be the optimal capital structure for this airline in this case, i.e., the capital structure that maximizes firm value? Use the adjusted WACC method to calculate the PV of the firm under the optimal capital structure. (iv) 5% + (25%) (v) A manager of a company who is seeking funds to finance a specific project notices that investors tend to overvalue equity in his company. Without doing any calculations, discuss how this observation can affect his capital structure decision. (15%)

Explanation / Answer

Inflow= £4,500,000

Tax=£ 1,125,000

      Net Inflow =         £ 3,375,000

      Discounting this net inflow with after-tax cost of capital =

            =          3,375,000/ (1+15%)

            =          3,375,000/ (1.15)

            =          £2,934,782

Inflow= £4,500,000

Interest= £     45,000

£4,455,000

Tax= £1,113,750

      Net Inflow =         £3,341,250

      Discounting this net inflow with after-tax cost of capital =

            =          3,341,250/ (1+15%)

            =          3,341,250/ (1.15)

            =          £2,905,434

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