1. [15 points] ABC Corp. is considering expansion of its production capacity by
ID: 2753520 • Letter: 1
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
We first have to calculate WACC fpr this project as follows
Debt weight = 1/3
Equity weight = 2/3
Before tax cost of debt = 10%
Cost of equity = 15%
So WACC = (1/3) * 10% * (1-30%) + (2/3) * 15% = 12.33%
Now we have to calculate free cash flow to equity for each year and then calculate NPV
Since nothing has been discussed about depreciation, we cannot take into consideration of depreciation tax shield. Otherwise initial investment is depreciated each year and tax shield is calculated accordingly.
Salvage value of the project = Next year cash flow / WACC = (5-1) / 12.33% = 4 / 12.33% = 32.44
This value is added into 3rd year's cash flow in the below table
NPV of this project can be calculated as follows
NPV = NPV(12.33%,F3:F5) - 30.00 = $-2.51 million
Year Cash flow Interest Cash flow to Equity Tax rate After Tax 0 -30.00 0.00 -30.00 30% -30.00 1 10.00 1.00 9.00 30% 6.30 2 8.00 1.00 7.00 30% 4.90 3 5.00 1.00 36.44 30% 25.51Related Questions
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