1. [15 points] ABC Corp. is considering expansion of its production capacity by

Question

1. [15 points] ABC Corp. is considering expansion of its production capacity by investing in a project with the following unlevered cash flows (UCF): Year 0: -$30 million Year 1: +$10 million Year 2: +$8 million Year 3 and all future years: +$5 million ABC Corp. will finance this expansion both with internal cash and by selling $10 million in bonds. The bonds pay interest of 10%. Although the current expected return on ABC’s stock is not known, it is known that the expected return on its stock would be 15% if the firm did not have any debt. The firm is expected to maintain a current debt-equity ratio of 1/2 for the foreseeable future. The corporate income tax rate is 30%. Ignoring the costs of financial distress and issue costs, calculate the net present value of this project using the Flow-To-Equity (FTE) approach.

Explanation / Answer

Actual result may vary with the given result to you due to difference in discounting factor digits used, Here 4 digit factor used for accuracy. ABC Corp Cost of Debt=Kd= 10% Debt /Equity =1/2 Tax rate =T= 30% Unlevered cost of Equity=Kug= 15% Assume cost of levered equity=Kg Kg=Kug+(1-T)*D/E(Kug-Kd) =0.15+0.70*0.50*(0.15-0.10)                0.018 =0.15+0.018 =16.8% So cost of levered equity= 16.80% Amount of Debt         10,000,000 NPV by Flow to Equity Approach Year 0 Year 1 Year 2 Year 3 Equity Invested         20,000,000 Unlevered cash Flow      10,000,000          8,000,000        33,333,333 ( =5000000/15% to derive value of all cash flows from Year 3 at unleverd equity cost) Interest on Debt        1,000,000          1,000,000        10,000,000 =(1000000/10% for perpetuity) Income before Tax        9,000,000          7,000,000        23,333,333 Income Tax@30%        2,700,000          2,100,000          7,000,000 Income After Tax        6,300,000          4,900,000        16,333,333 Return to Equity=        6,300,000          4,900,000        16,333,333 Discount Factor @16.8%                            1              0.8562                0.7330                0.6276 PV of Return to Equity        5,393,836          3,591,786        10,250,529 PV of Total of Return to equity =         19,236,151 NPV =(19,236151-20,000,000) = $ (763,849.44)

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