6. Company A is considering a project (the only project for the company) with th

Question

6. Company A is considering a project (the only project for the company) with the following estimated unlevered cash flows: (Two years life time for the company) Year 2 $2,000 600 $1,400 Year 1 EBIT $%1,000 300 $700 Tax@30% Company A finances its projects with 70% equity and 30% debt. The firm has calculated its cost of equity to be 12%. The corporate tax rate is 40% and interest on debt is tax deductible. The borrowing cost for the firm is 6%. a) Using the FCFs and WACC to calculate the leveraged firm value [6 Marks] Using the un-levered CF and Tax-Shied Cash Flows to calculate their present values (and the leveraged firm value equals the sum of the two) b) [6 Marks] Will the results (of the leveraged firm value) in the above two be equal? (Simple answer with "Yes" or "No" is not enough; you should provide your explanation.) c) 18 Marks] Total [20 Marks] Useful formulae for the Question 6: WACC-Re*We+Rd*Wd* (1-To) Re-Ru (Ru-Rd) (D/E)

Explanation / Answer

Answer (A) finance 70% equity and 30% debt Given Information Equity Debt Cost 12% 6% Weight 70% 30% Tc = 40% Wacc = Re*We + Rd*Wd(1-Tc) 9.48% Future Cash flows wacc Ebit/ko Year 1 1000 9.48% 10548.52 Year 2 2000 9.48% 21097.05 Value of leveraged firm = Ebit/ko Answer (B) Year 1 Year 2 EBIT 1000 2000 Less:- 300 600 EAT 700 1400 PVF@12% 0.893 0.797 Present values 625 1116.07 Answer © No the result of the above two is not equal REASON :- Because in th case of leveraged firm the WACC comes 9.48% because it is leveraged firm it includes equity and debt both While the WACC of unleveraged firm is 12% as it is unleveraged firm means there is no cost of debt since no debt capital so the cost of equity is referred as WACC

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