You are a consultant who has been hired to evaluate a new product line for Marku

Question

You are a consultant who has been hired to evaluate a new product line for Markum Enterprises. The upfront investment required to launch the product line is

$ 6 million. The product will generate free cash flow of $0.80 million the first year, and this free cash flow is expected to grow at a rate of 6%

per year. Markum has an equity cost of capital of 11.2%, a debt cost of capital of 5.82%, and a tax rate of 35%. Markum maintains a debt-equity ratio of 0.40.

a. What is the NPV of the new product line (including any tax shields from leverage)?

b. How much debt will Markum initially take on as a result of launching this product line?

c. How much of the product line's value is attributable to the present value of interest tax shields?

Explanation / Answer

Initial cost = $6 million

Initial cash flow = 0.8 million

Growth rate = 6%

WACC rate = 11.2% *1/1.4 + 5.8%*(1-0.35)*0.4/1.4

= 8% + 1.077

= 9.077%

Value of new product line = 0.8/ (9.077%-6%) = $26 million

Npv= $26 million – 6 million = $20 million

B

Debt = 26 million* 0.4/1.4 = $7.43 million

C

Wacc without tax shield = 11.2% *1/1.4 + 5.8%*0.4/1.4 = 9.66%

Unlevered value of the product line = 0.8/ ( 9.66%- 6%) = $ 21.86 million

Value of tax shield = $26 m - $21.86 m

= $4.14 million

Related Questions

Navigate

• Browse (All)
• Browse Y
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.