Suppose Alcatel-Lucent has an equity cost of capital of 9.1%, market capitalizat

Question

Suppose Alcatel-Lucent has an equity cost of capital of 9.1%, market capitalization of $10.95 billion, and an enterprise value of $15 billion. Suppose Alcatel-Lucent's debt cost of capital is 5.6% and its marginal tax rate is 34%.

a. What is Alcatel-Lucent's WACC? 7.64%

b. If Alcatel-Lucent maintains a constant debt-equity ratio, what is the value of a project with average risk and the expected free cash flows as shown here,

Year 0 =-100 (FCF $ Million) Year 1= 52 (FCF $ Million) Year 3= 103 (FCF $ Million) Year 1= 66 (FCF $ Million)? The NPV of the project is $90.13 million   

c.If Alcatel-Lucent maintains its debt-equity ratio, what is the debt capacity of the project in part

(b) is as follows: (Round to two decimal places)

Year 0 = Debt capacity $ ? million,  Year 1 = Debt capacity $ ? million, Year 2 = Debt capacity $ ? million, Year 3 = Debt capacity $ ? million,

Explanation / Answer

a. WACC= Cost of equityX Wtg of equity+(1-tax rate)Xcost of debt Xwtg of debt

=(9.1%X(10.95/15))+((1-0.34)X5.6%X((15-10.95)/15)=7.64%

b. Value of project= NPV

NPV= Present value of all future cash flows discounted at WACC(Wtd Avg Cost of Capital).

In this case WACC=7.64%

NPV= -100 +(52)/(1+7.64%)+(66)/(1+7.64%)^2+(103)/(1+7.64%)^3

NPV=90.13 million

Debt capcity= Cash flows/Debt cost

Debt cost= interest rate on debtX(1-tax rate)Xamount borrowed

Debt cost each year= 5.6%X(1-0.34)X(15-10.95)

Debt cost each year= 149.68 million

Debt servicing capacity year 1= 52/149.68= 0.34

year 2= 66/149.68= 0.44

Year 3= 103/149.68= 0.688

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