I am undertaking a project that will cost $500 million to start up. It will be f

Question

I am undertaking a project that will cost $500 million to start up. It will be financed in equal parts of equity and nonrecourse debt. The debt will be 6% with an infinite term to maturity (interest only, forever), and the size of that debt load will be constant throughout the life of the project, which is indefinite. My firm’s tax rate is 35%. The total cash flows from the project will be approximately $35 million each year.

I have examined a number of comparable companies to my firm and discovered that most of them have similar equity betas. When I unlever these betas, I find the average unlevered beta for these comparable firms is 0.78. Assume a universal debt beta of 0.20, a market risk premium of 5%, and a risk-free rate of 3%.

1. When I start this project, how will it affect my total balance sheet size – what will the change be in total assets?

2. Assume I value this project using a FTTE (flow-through-to-equity) approach. What are my yearly cash flows? (Actual number!)

3. To get the actual value of this project requires an iterative process. Run through two iterations to get a preliminary estimate of the value of this project to the firm:

The only thing I now how to do is solve for cost of equity using CAPM

Explanation / Answer

Cost of Debt= Risk-Free rate+Debt Beta(Market risk premium)                                   = 0.03+0.20*(0.05) = 0.04 ie. 4% Cost of Equity= Risk-Free rate+Equity Beta(Market risk premium)                             =0.03+0.78*(0.05) = 0.069 ie. 6.9% 1 The change in total assets will be $ 500 Million (Corresponding to addition of $ 250 Mn. Equity & $ 250 Mn. Non-recourse Debt on the liability side of the Balance Sheet) 2 Total Cash flows 35000000 Less: Int. on Debt @ 6%*250000000 15000000 20000000 Less: Tax @ 35% 7000000 Net annual cash flow to Equity holders 13000000 3 Value of the project is the value of these indefinite annual cash flows discounted at the cost of Equity ,ie. 6.9% 13000000/0.069 Value of the project= 188405797 Assuming the cost of Debt as 4% as found through CAPM Total Cash flows 35000000 Less: Int. on Debt @ 4%*250000000 10000000 25000000 Less: Tax @ 35% 8750000 Net annual cash flow to Equity holders 16250000 Value of the project is the value of these indefinite annual cash flows discounted at the cost of Equity ,ie. 6.9% 16250000/0.069 Value of the project= 235507246 Preliminary estimate of the value of the project may be assumed to be the mid-point of the above two values ie. (188405797+235507246)/2 211956522

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