1. [10 points] ABC Corp. is considering expansion of its production capacity by

ID: 2768695 • Letter: 1

Question

1. [10 points] ABC Corp. is considering expansion of its production capacity by investing in a project with the following unlevered cash flows (UCF):

Year 0: -$20 million

Year 1: +$5 million

Year 2: +$8 million

Year 3 and all future years: +$10 million

ABC Corp. will finance this expansion both with internal cash and by selling $10 million in bonds. The bonds pay interest of 10%. The expected return on ABC’s stock is 20% and firm is expected to maintain a debt-equity ratio of 1 for the foreseeable future. The corporate income tax rate is 20%. 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

First we need to compute WACC:

Wd = 10 million/20 million = 0.50

We = 1-0.50 = 0.50

Cost of debt Kd = Rd x (1-t)

= 10% x (1-0.20)

= 8%

WACC = Kd x Wd + Ke x We

= 0.08 x 0.50 + 0.20 x 0.50

=14%

Now we need to discount all cash flows.

PV of perpetual cash flows at year 2 = year 3 cash flow/ cost of capital

= 10 million/ 0.14

= 71.43 million

Now we need to compute pv of all cash flows to get NPV:

year

Cash flow

PV factor 14%

-20

1.0000

-20.00

0.8772

4.39

79.43

0.7695

61.12

45.50

So, NPV is 45.50 million.