C4 A1 Q15 Questions 11-20 are related to the same Mega problem. In Europe the ai

Question

C4 A1 Q15

Questions 11-20 are related to the same Mega problem. In Europe the airlines and railway sectors are competing for the travel needs of the increasingly mobile and massive consumer market. TravelWithUs, a leading airline company is looking to create a new joint venture with FromHereToThere, Inc. a dominant player in the rapid transit railway sector that will provide a huge opportunity to create value through cost reductions in the excessive competition between the two sectors. This joint venture will also be able to provide new travel options to an increasingly demanding customer, combining air and travel routes, to minimize the time taken to travel between various destinations. The new joint venture will have an asset beta equal to 80% the sum of the asset beta of the airline and railway businesses. The joint venture would require a $20 billion investment and would generate after tax free cash flows of about $2.75 billion starting the following year (t = 1) and will grow at the rate of inflation of 3% for the foreseeable future. The joint venture would be financed by a $10 billion issuance of new stock each by TravelWithUs., Inc. and HereToThere, Inc. that will give each company a 50% ownership in the joint venture.

TravelWithUs., Inc. has a market value of equity of $50 billion and an industry average debt to equity ratio of 0.60. On the other hand, HereToThere, Inc. has a market value of equity of $25.00 billion and an industry average debt to equity ratio of 0.50. The airline business has an average beta of equity of 2.50, while the average equity beta in the railway business is 1.75. The average returns on debt in the airline and railway industries are 8.00% and 6.75%, respectively. The risk free rate is 2.50% and the expected market risk premium (the difference between the market return and the risk free rate) is 4.00% for the foreseeable future. Assume that the tax rate is 34%, the interest payments on debt are tax deductible and the tax shield on debt is as risky as the assets of a business. What is the return on assets of the joint venture? (No more than two decimals in the percentage but do not enter the % sign.)

Explanation / Answer

After Tax Free Cash Flows = Net Income + Interest Expense + Annual Depreciation - Changes in Net Working Capital

Since the joint venture is entirely equity financed, the interest expense would be zero. Annual Depreciation and Working Capital changes would be also be zero as details about the same ae not mentioned and can be safely assumed to be zero.

Therefore, After Tax Free Cash Flows = $ 2.75 billion = Net Income

Total Assets (of Joint Vennture) = Total Initial Equity Issuance = $ 20 billion (debt is zero)

Therefore, Return on Asset = (Net Income / Total Assets) x 100 (this is only for year 1. ROA will vary with net income for each year)

ROA = (2.75 / 20) x 100 = 13.75 % (Only for Year 1) (Total Assets will always be taken at book value)

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